How To Get 15% Returns In Real Estate Investing

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Includes: BAM, BJRI, BPR, CVS, DG, HD, O, PLYM, SRC, VNQ, WBA
by: Jussi Askola
Summary

Investing in real estate can quite reasonably achieve 15% returns over the long term, thanks to cheap leverage and inflation.

As a result, many investors prefer this approach to investing in the stock market.

However, investing in real estate is traditionally much more demanding and also requires significant access to capital, not to mention the risks associated with taking on significant personal debt.

We believe that REITs offer investors the best of both worlds, if done right.

In this article, we outline the basic math behind our investment approach.

Investing in real estate can quite reasonably achieve 15% returns over the long term, thanks to cheap leverage and inflation. The basic calculation is as follows: buy a 6% cap rate property with a 30% down payment at a 5% interest rate. The cash-on-cash yield works out to be 8.3%. Factor in appreciation at 2% (the approximate current rate of inflation), and you get another 6.7% of total returns, putting you at 15% total returns. This is a very realistic scenario and in fact is quite conservative for some properties where other investors will often put down only 20-25% per property. Of course, leverage cuts both ways and can also quickly wipe out investor equity in a down market. That is why we chose a more “conservative” 30% down payment level for our base assumption.

For this reason, many investors strongly favor this approach to stock market investing since the projected long-term returns are greater and they do not have to deal with the psychological stress that comes with the daily volatility seen in the stock market (which typically averages around 8-12% returns per year over the long run).

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While this may seem like an “easy” path to wealth for the average investor, there is a reason why many do not/cannot go this route. First of all, they are a pain to manage due to the big, ugly "triple Ts":

  1. Tenants
  2. Toilets
  3. Trash

Managing properties takes time, expertise, and a lot of work in dealing with tenants and property upkeep. In many cases, owning rentals gets closer to operating a business rather than just collecting passive income from an investment. Moreover, your property is going to be an illiquid, leveraged, and concentrated investment with high transaction cost and personal liability.

So while there is a lot to like about rental investments, the returns clearly do not come for free. Fortunately, there is a solution to gain similar exposure without all the downsides of investing in the private market and taking the role of the landlord.

Enter: REITs

REITs are corporations that generate income through the collection of rent on and from sales of the properties they own for the long term. Just like mutual funds, they allow investors of all kinds to invest in real estate without actually having to go out and buy, manage, and finance properties themselves. Besides, most REITs are publicly traded on a stock exchange and allow investors to participate in the ownership of large scale, well-diversified real estate portfolios in the same way as investors would invest in any other industry - through the purchase of stocks.

We are big fans of REITs because they essentially combine the positive attributes of stocks:

  • Liquidity
  • Low transaction cost
  • No managerial work

With the benefits of real estate:

  • Higher total returns due to cheap leverage
  • High and stable cash flow
  • Inflation protection

As a result, REITs have historically produced up to 4x higher total returns than the S&P 500 from 1997 until 2016:

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So, rather than invest in rental properties and having to deal with tenants, toilets, and trash, most investors would be better off to just invest in the shares of publicly traded REITs which enjoy liquidity, low transaction, professional management and greater diversification.

In fact, REITs have even outperformed private real estate investments, according to EPRA due to their greater scale, lower borrowing cost, and greater access to better deals and resources:

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As we can see from the chart above, REITs average a very strong 12.4% annual return over the long term, with its performance gap with other asset classes exploding exponentially over time. While this appears to be lower than the 15% returns we outlined in the real estate example listed at the beginning of the article, we need to remember that the illustration given assumed a higher amount of leverage than what REITs typically use (most REITs use 30-50%), meaning that REITs pose less risk to investors. If we just adjust the leverage in the previous example to 50% (on the aggressive end of many REITs), we see that the projected annualized total returns drop to 11%, which would be underperforming REITs with still greater than average leverage risk to equity. This shows that REITs due to their aforementioned advantages perform at a better risk-adjusted return to their private real estate market counterparts.

In our real-money portfolio at High Yield Landlord, however, we aim to outperform even these strong numbers by putting the favorable math of real estate investing on steroids. Our secret? Buying solid REITs at discounts to NAV. In other words, we buy highly diversified portfolios of quality real estate that is managed by professionals and which enjoy economies of scale and in most cases cheaper leverage than we could get for ourselves at a discount to the price they are selling for in the private market. In so doing, we believe we can achieve the 15%+ returns projected at the beginning of this article while taking on considerably less risk and headache than a heavily leveraged private-market investment would require.

Here is the simple math: our weighted portfolio dividend yield is currently ~8% and a weighted cash flow yield of 10.6%, with average leverage of only 38% (i.e., half of what most private market investors use). Assuming that half of the retained cash flows are used for maintenance (i.e., non-growth oriented) and the other half is deployed into growth, we get a total cash flow return of ~9.3%. Adding in 2% average appreciation on our properties at their current 38% leverage, we get an additional 3.2% annual return, bringing our total to the long-term average of 12.5%. However, this is where our secret sauce comes into play: we believe our REITs in aggregate are undervalued by at least 15% relative to their NAV. Assuming it takes 5 years on average for this gap to close, we get an additional annualized return of 2.8-2.9%, pushing us over the 15% annualized target return.

To add an additional margin of safety to our target annualized rate of return, we also engage in occasional active trading in our portfolios by opportunistically selling options in special circumstances to enhance returns or even opportunistically trimming/selling a position when the price appreciates close to our NAV estimate in order to redeploy the capital into more opportunistic investments. These last two factors are what convince us that publicly traded REITs are the best risk-adjusted way to invest in real estate today because neither is possible with owning individual properties.

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Some of the picks that we believe remain significantly undervalued relative to NAV in our portfolio today include: Spirit Realty Capital (SRC), Brookfield Property REIT (BPR), and Plymouth Industrial REIT (PLYM).

We are bullish on SRC because the average remaining lease term is very long at ~10 years, the tenants are high-quality retailers such as Walgreens (WBA), Dollar General (DG), CVS (CVS), Circle K, BJ's (BJRI), and Home Depot (HD), the company is enjoying a 2-3x rent coverage with most tenants – meaning that the tenants would need to lose more than half of their profits before having troubles to pay rent, the leases include protections against inflation with automatically increasing rents and zero landlord responsibilities in most cases, and the company uses little leverage, and we expect a credit upgrade in the near future. Meanwhile, it trades at nearly twice the cash flow yield of Realty Income (O), despite its portfolio and business model being nearly identical.

We love PLYM because, though it IPOed at $18-19 per share in 2017, the company is down to just $15 today. It is hard to destroy that much value in under two years, especially when investing in industrial real estate. We believe that the shares remain at a compelling discount to NAV despite their recent recovery. Furthermore, management is taking concrete steps to continue to expand economies of scale through accretive acquisitions and is also making much-needed improvements to the balance sheet.

BPR is also one of our prized holdings due to its high-quality portfolio, strong management, and substantial discount to NAV (~33% based on IFRS valuations). As an owner of world-class properties and backed by A-rated Brookfield Asset Management (BAM) – one of the world’s largest real asset investors and managers – it is a true blue-chip REIT and perhaps the greatest bargain in publicly traded real estate today. To close the discount to NAV, management is aggressively repurchasing shares alongside its parent and majority shareholder BAM. We also expect cash flow per share to grow at a brisk 5-8% pace over the next several years thanks to its robust development pipeline, operational expertise, share buybacks, and effective capital recycling program. Combined with its 10% cash flow yield and 6.5% dividend yield, BPR is poised for high-teens annualized total returns over the next several years.

Investor Takeaway

As we have shown above, private real estate investing can be very lucrative for those with the ambition and risk tolerance to roll up their sleeves and play landlord while also taking on enormous debt obligations. However, if their properties go vacant during a recessionary period, they will not only find their properties to be a liability rather than a cash-flowing asset, but they will also likely find them to be fairly illiquid.

REITs, on the other hand, provide stronger risk-adjusted returns while also providing enormous liquidity and the ease of complete passivity. However, in order to achieve outsized returns, due diligence is still required to locate REITs that trade at discounts to NAV while still possessing the quality attributes necessary to remain fairly low-risk, long-term investments.

Many investors may prefer to simply invest in a REIT ETF such as the popular Vanguard REIT Index fund (VNQ).

Disclosure: I am/we are long BAM; BPR; SRC; PLYM. 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.