Don't Buy Real Estate, Buy REITs Instead

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Includes: O, PLD, PSA, SPG, SPY, STOR, VNQ
by: Jussi Askola
Summary

REITs have historically generated total returns far exceeding those of private real estate investments.

As strange as it may sound, private real estate investors took greater risks to achieve those subpar results.

REITs are able to grow their cash flow at faster rates thanks to better access to different capital sources not available to private investors.

REITs are also much more efficient at minimizing costs and mitigating risks.

Our REIT portfolio pays an ~8.5% dividend yield with a safe 72% payout ratio, strong diversification, and growth potential. Can private real estate investors beat that?

Income-producing real estate has historically generated higher returns with lesser risk than most stocks while providing valuable diversification benefits. In fact, real estate (VNQ) produced up to 4x higher total returns than the S&P 500 (SPY) from 1997 until 2016:

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Therefore, most investors understand that they should invest in real estate whether it's for:

  • High current income.
  • Long-term appreciation.
  • Inflation protection.
  • Diversification.

The more difficult part is to determine HOW to invest in real estate? When looking at all the different possibilities, most investors consider two main options:

Option 1: Invest in private real estate (or a private real estate fund)

Option 2: Invest in publicly traded REITs

We think that this article can help you decide. For us, there's no doubt: REITs are much better vehicles for long-term real estate investing. And we do not say this lightly. I have myself a background in private equity real estate and once thought that there was no better way. The truth is that I was investing in private real estate because I did not know better and suffered from many misconceptions on REIT investing. Today, I have turned my back to private equity and my real estate portfolio is (almost) fully invested in REITs.

The reason why we are so confident in our choice is because REITs have not only massively outperformed private real estate in the past, they have done so while taking significantly less risk.

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From 1992 until 2017, REITs returned more than 11% per year. In comparison, private equity real estate investments returned just 7% on average, or a ~4% annual underperformance.

In other words, if you had a million dollars 25 years ago and invested it in REITs rather than in private equity real estate, you would have nearly two and half times more today. Interestingly, REITs crushed private peers with much lower average leverage, better diversification, a stronger focus on quality properties, and less risky strategies in general.

While this outcome may sound surprising at first, it's very much expected and even normal. There are real economic reasons why REITs outperform and why this outperformance is expected to continue.

We identify three main reasons why REITs outperform private real estate investments in the long run.

1. REITs Achieve Higher Growth Rates Thanks to Better Access to Different Capital Sources

While private real estate investors are limited to raising rents and occupancy levels to grow NOI, REITs have many more opportunities to boost growth beyond what's possible to private investors.

The most common way for REITs to increase growth rates is by issuing new shares, raising new debt, and investing these proceeds in new acquisitions. As long as the average cost of capital is lower than the expected return of the property, there's a positive spread to be earned for the existing REIT shareholders. We call this “external” growth – or “spread” investing.

Consider the following example:

REIT “X” issues 1,000,000 additional shares at $30 each for $30,000,000 and adds another $20,000,000 of debt. The total $50,000,000 capital stack costs the company 6.5% per year, but it's able to invest the proceeds in a property yielding 8% annually. There's an immediate 150 basis point of profit to be added to the bottom line of shareholders. Even if the share count goes up, the cash flow per share increases – creating value to shareholders.

This is simply not possible to private real estate investors who are not able to issue new shares on a public exchange to raise additional capital and boost their growth rate. Being more limited, private investors must content themselves with inferior growth by mostly raising rents over time.

While private investors may be happy with a 2% annual growth rate in cash flow, REITs can grow by 5%-10% per year by doing spread investing in addition to raising rents.

Realty Income (O) is a great example here. It has grown cash flow very consistently at an average of 5.2% per share in the last 20 years-plus by complementing rent increases with spread investing.

The company returned to shareholders on average ~16% per year from a lower-risk net lease approach with quality properties and little leverage. This is simply not possible for the vast majority of private real estate investors which would have been happy with 2x smaller returns over the same time horizon for similar assets.

If REITs can consistently achieve stronger growth rates than private peers, it's then not surprising that REITs have historically outperformed. Most importantly, this competitive advantage has not changed and will result in more future outperformance. Private investors are just too limited in their access to different capital sources and it hurts their growth potential. REITs can issue new common shares, preferred shares, baby bonds, convertible bonds, and countless many other variants of capital not available to private investors.

2. REITs Are Better at Mitigating Risks

REITs offer the opportunity to invest in broad and widely diversified portfolios of properties in a liquid and cost-efficient manner. With REITs, you can easily invest in all property sectors including office, retail, industrial, residential and many other specialty sectors in almost any geographical location.

It results in significant risk mitigation as compared to private investments, which are likely to be much more concentrated in nature. Being concentrated can sometimes lead to higher returns, but it's also clearly a riskier strategy that has historically not even paid off.

REITs also greatly reduce the risk of illiquidity as they can be freely traded on liquid markets at minimal transaction cost. In comparison, buying and selling a private property or investing in a private fund is very costly and time consuming. It's common to pay somewhere between 5-10 percent of the purchase price in different fees and transaction costs when buying and/or selling a property. It dilutes returns considerably for the investor who is essentially losing up to 10% on day one in fees alone. In comparison, REITs already have paid all property-level transaction costs and own a portfolio in which you can invest by buying shares, saving the real underlying cost of real estate transactions.

3. REITs Are More Cost Efficient

REITs also are able to save costs at many levels, including interest expenses, property management and brokerage. Scale brings cost-efficiency, and the superior relationships of REITs give them a significant competitive advantage. Consider a private investor walking into a bank to ask for a loan, vs. a $10 billion REIT walking into the same bank. Who is likely to get the best terms on their financing? The cost savings of REITs can be massive.

Some studies find that REITs have up to 4% head start per year from cost savings compared to other direct property investments. From my experience working in private equity real estate, it's in most cases very difficult for private market investors to ever catch up to this advantage – causing them to underperform in the long run when accounting for all additional expenses and fees.

Bottom Line

  1. REITs outperform real estate by a large margin despite being less risky on average.
  2. The outperformance is caused by real economics factors that will cause the outperformance to continue.
  3. Lower returns with higher risk is a difficult sell for private equity – and yet it continues to attract significant capital from investors who do not know any better.
  4. Long term-oriented investors are much better off investing in REITs.

Now, it's clear that in specific cases, certain private equity investors may manage to beat the average returns of REITs. There's no question about that. But the same also can be said about active REIT investors. As an example, GSA has managed to generate 22% annual returns on its BUY picks by following a value approach to REIT investing since 1993.

Source

Many private property investors commonly point out that they are able to earn higher cash flow yields by investing in private properties as compared to buying low yielding REITs such as STORE Capital (STOR), Simon Property Group (SPG), PublicStorage (PSA), or Prologis (PLD) with 3-5% dividend yields.

But they ignore that they could easily earn higher yields with REITs if they adapted their investment strategy toward that goal. At High-Yield Landlord, our Core Portfolio is designed to generate high, sustainable and growing cash flow. It currently pays an ~8% dividend yield with a safe 72% payout ratio - allowing for further growth and appreciation potential.

We aim to hand-pick only the REITs offering the greatest return potential and have built a diversified portfolio with 20 positions. By pursuing this approach to real estate investing, we expect to outperform the great majority of private real estate investors with less effort and less risk.

Disclosure: I am/we are long ALL STOCKS IN CORE PORTFOLIO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.