Bursting Bubble Or Booming Market: Real Estate In 2019

Summary

• 97% of real estate investors plan to increase their capital allocation to real estate in the next 18 months.
• Why? Real estate remains one of the last asset classes with attractive total return and income generation potential.
• Our 7.5%-yielding portfolio of undervalued REITs is well-positioned to thrive in this environment.
• Looking for a portfolio of ideas like this one? Members of High Yield Landlord get exclusive access to our model portfolio. Get started today »

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In a recent survey conducted by Deloitte, 97% of global investors expressed their intention to increase investments in real estate within the coming 18 months. It is very interesting because we are now in the 11th year to our economic cycle and all we hear in the news is:

• Recession
• Trade war
• Inverted yield curve
• Risky monetary policies
• Brexit
• Debt crisis
• Etc…

…And yet, private real estate investors remain overwhelmingly bullish. Respondents from the United States plan to increase their allocation by 13% over the next 18 months. Investors from Germany and Canada showed similar levels of interest.

Why are investors rushing into real estate?

Real estate remains one of the most opportunistic asset classes in 2019. This is not just my opinion, but that of 500 global asset managers who expect to increase investments to this asset class.

It is one of the few sectors that continues to provide a healthy combination of income and growth that can be safely leveraged with cheap capital to produce attractive total returns in the long run.

Still to this day, you can buy a property at a 7% cap rate, finance half of it at a 4% interest rate and earn 10% cash on cash returns from a long lease term with quality tenants and wait for inflation to make its magic in the long run.

In comparison, if you invest today in the 2% yielding treasury bonds or in the expensively priced S&P500 (SPY) at 22x Earnings – what are your return prospects? I personally do not know, but it sure sounds more uncertain than that of the property described above.

Below we present 3 key reasons why we believe that real estate investors still may have many good years ahead:

Reason #1: Real Estate Cycle Has More Room for Expansion

Historically, the complete real estate market cycle has had an average duration of about 18 years, and we are currently only in the 11th year to it.

Moreover, compared to the two previous real estate cycles, the current one has been very mild in magnitude with unspectacular returns in its expansion phase.

Source: NAREIT

In a research report from NAREIT, Brad Case notes that:

• In the 1970s and '80s, the expansion phase ran 155 months from September 1976 through August 1989 gave total returns averaging 18.7% per year.
• In the 1990s and 2000s, the expansion phase ran 190 months from March 1991 through January 2007 them total returns averaging 15.8% per year.

In comparison, today’s expansion phase has run only a total of 85 months from July 2012 through August 2019 and given total returns averaging “only” 9.7% per year.

It leaves us optimist that the current real estate cycle could still have a long way to go. To reach the historical averages, the real estate market would need to keep rising for another 7 years with sharper annual appreciation.

Reason #2: Income in a Yieldless World

Almost every asset is historically expensive right now. Interest rates are very low for bonds. P/E ratios are expensive for stocks. And cap rates are on the low side for real estate.

Still, as discussed earlier, there remains good potential for real estate to generate strong returns and income for investors. It is all “relative” in the end, and while a decent property may produce a 10% leveraged cash on cash yield – comparable stock investments with similar risk profiles – are unlikely to come even close to that.

It is true that there are always the FANG stocks Facebook (FB), Amazon (AMZN), Netflix (NFLX) and Alphabet (GOOG) that may grow cash flow at a much faster rate than properties – but betting on appreciation is a completely different ballgame from earning consistent income month after month.

With the 10-year treasury paying just 2% - investors need INCOME and real estate is the last remaining asset class of scale that can provide safe and growing income in 2019.

Reason #3: Fundamentals Remain Favorable

Real estate prices continue to rise on the back of steady economic growth. This is the direct result of continued NOI growth in an environment where cap rates have remained fairly steady amid strong demand for property investments:

Source: NAREIT

Most property sectors are higher today than last year. Leading the pack in terms of price appreciation and total returns, we have Self-Storage, Industrial and Manufactured Housing - three sectors that we overweight within our diversified Real Estate Portfolio at High Yield Landlord.

Price increases in real estate become unsustainable if they continually exceed the growth of NOI. This is not the case today with demand growth outpacing new supply in most property sectors - allowing landlords to keep raising rents and achieving NOI growth.

Rent growth of apartments, office, retail and industrial are all positive:

Source: NAREIT

The vacancy rate is also at a historically low level for most property sectors, with a continued trend towards even lower rates.

Source: NAREIT

It is then not surprising that properties continue to appreciate. The lower the vacancy rate, the more rent increases can be enforced - pushing property values higher and higher.

With the economic expansion likely to continue in 2020, and strong property market fundamentals, we expect the appreciation to continue. The good thing is that even if we are wrong and go into a recession tomorrow, that won’t be a catastrophe for real estate investors who enjoy long lease terms and steady cash flow.

Real Estate Investment Strategy for Individual Investors

OK, so real estate remains an attractive asset class that is in particularly high demand from professional investors. What's next? How is the average do-it-yourself investor supposed to put this into practice to profit from the rush to real estate? While the arguments for real estate over financial assets may seem convincing, many small investors – especially retirees – are intimidated and/or scared away by their illiquidity, inefficiency (especially when purchased on a small scale), lack of passivity, and even liability.

Fortunately, you do not need to be a multi-billion-dollar institution to invest in income producing real estate. At High Yield Landlord, we specialize in helping the individual investors enjoy the best of both worlds by investing in financial assets that are directly backed by real estate (often referred to as "REITs"). We have a strong preference for relying on these REIT investments rather than traditional physical real estate due to the numerous advantages they offer:

• Economies of scale – Large portfolios of real estate are much cheaper to operate per unit than smaller portfolios due to the fact that larger portfolios have greater bargaining power with suppliers, sales and marketing agents, tenants, property management, and maintenance companies and can also spread fixed costs out over a much larger amount of rental revenue, resulting in significantly higher profit margins.

• Safety through broad diversification – If one or two real estate investments encounter problems and/or underperform, large portfolios can absorb this blow quite easily whereas small portfolios will be unable to.

• Easy liquidity – The ability to quickly and cheaply buy and sell real asset investments through publicly traded entities makes for considerably less risk, cost, and commitment than is born in typical physical real asset investments.

• Professional management – Owning real estate managed by professionals with decades of experience and – ideally – skin in the game, offers a huge competitive advantage over having to manage the investments yourself. REITs are totally passive investments.

• Transparency – Despite being totally passive, these entities are bound by law to release quarterly, semi-annual, and/or annual reports on their business, providing tremendous transparency and insight into the performance of your real assets.

• Occasionally trading at discounts to NAV – Thanks to the tendency for publicly-traded markets to fluctuate wildly with daily news headlines that are often entirely disconnected from the underlying performance of the properties, it's not uncommon for these investments – despite all of their advantages – to trade at discounts to the value of their underlying holdings. This provides savvy investors with the opportunity to achieve profits that exceed the already superior total return outlook for real assets.

With that said, not every REIT will do. Some are overpriced and risky, while others are undervalued and defensive.

There exists over 200 potential choices. We screen it down to just 19 names in which we actively invest:

Below we present an example of an attractive REIT in which we may invest in the near term.

Potential Investment Candidate:

One Liberty Properties (OLP) is a net lease REIT, just like Realty Income (O), but rather than trade at 22x FFO, OLP is currently offered at around 12x FFO - a full 10-turn lower multiple than the popular large cap. The massive discount lets you assume that the company must have some serious issues, but the reality is that this is a quality company and it does not present any of the previously mentioned problems:

• The management owns 22% of the shares - Assuring interest-alignment and a strong focus on shareholder-friendly management.
• The portfolio is diverse with the largest exposure to high-demand industrial properties at 37.5% of the rental income.
• The average remaining lease term is over eight years - providing consistent cash flow for years to come. Finally, the balance sheet is adequately structured.

The company has significantly outperformed the REIT market in the past 10 years with total returns reaching 13.5% compared to 7.9% for the average REIT:

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Moreover, the company yields close to 6.5% and the dividend is on the rise:

The point here is not to argue that OLP deserves to trade at the same valuation as Realty Income because it does not. But given the high quality nature of the operations, the strong track record and the sector-leading management alignment, we believe that OLP is a good example of a small-cap REIT that is likely to outperform larger peers going forward.

It's by targeting this type of small-cap REITs that we still find plenty of value in the real estate sector even in August of 2019.

As of today, our Core Portfolio has a dividend yield of 7.2% with a conservative 68% payout ratio despite a yield that's almost double the index. Beyond the dividends, the core holdings are trading substantially below intrinsic value at just 9.5x FFO - providing both margin of safety and capital appreciation potential:

Source: High Yield Landlord Real-Money Portfolio

Closing Note

Still, 20 years ago, most investors would ignore real estate. Today, they are becoming a major allocation in the portfolios of professional investors:

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As the saying goes...

"Follow the money."

With more and more capital chasing a limited number of deals, we expect real estate to continue appreciating and outperform financial assets (stocks and bonds) in the coming decades.

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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in OLP over the next 72 hours. 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.