Businesses come and go. Some are naturally more resilient than others, but there's very little to protect your average business from failing and going bankrupt. In fact, studies have shown that up to 70% of small businesses fail within their first 10 years. A whopping 70% of value destruction!
Larger and publicly-traded companies may be more resilient, but they are not immune to bankruptcy either. Just think for a second about all the market leaders 10-20 years ago. Then think back to today.
The reality is that most businesses are much more volatile than you would like to admit. They operate in highly competitive markets and new innovations and competitors can emerge at any time. At one point Nokia controlled 40% of the mobile phone market and everybody thought that it would dominate for a very long time (just how people think of Apple today). Shortly after, new competitors emerged, Nokia lost its hype, and today, it's very rare to come across a Nokia anymore. Shareholders lost their shirt and it would have been very difficult for anyone to predict these events.
At High Yield Landlord, we invest heavily in real estate because it's the most resilient form of business that exists on this planet. Most small businesses fail within a few years, but it's very rare for a property owner to ever go bankrupt unless they are grossly overleveraged or mismanage the asset.
REIT bankruptcies are even more exceptional because they are well diversified, own strong assets and have good balance sheets. We can count only one case of REIT that was forced into bankruptcy and that's General Growth Properties (GGP). It happened in the mid of the great financial crisis due to overleverage, and even then, it eventually reemerged from bankruptcy and was bought out by Brookfield Property Partners (BPY).
The fact is that it's really difficult to bankrupt a diversified portfolio of conservatively financed properties. And this is why it happens so rarely.
REITs represent portfolios of properties ranging from office building to apartment complexes, hospitals, warehouses, shopping centers and even timberland.
These are properties that our society cannot live without. You just cannot live without apartment complexes or office buildings. They are absolutely needed for the well being and prosperity of our civilization. We need a roof over our head for most of our daily activities whether it's sleeping, working or shopping.
This real estate costs a lot to build and it's very valuable to its owner. Moreover, it's a finite commodity and high-quality properties that are well located always are in high demand. Since the supply is strictly limited, but demand is growing, the value of the property and its rents are growing over time and provide protection against inflation.
A regular company must generate new sales day after day and its performance is greatly affected by factors that are outside of its control. If the economy takes a nosedive, you might see your cash flow cut in half in just a few weeks. If your largest clients go bankrupt, you might have a very hard time to find a new one. If a new competitor emerges and has a better product and/or cuts prices, you are in big trouble.
With real estate, the cash flow is much more consistent, predictable and sustainable because it's a vital necessity to its occupant and there are long lease contracts in place to protect the landlord.
Just because we go into a recession won’t greatly affect the need for apartments. People won’t skip their rent payment unless they have no other choice. They are more likely to first cancel their Equinox membership and downgrade from a Lexus to a Honda (HMC).
And even if a tenant wanted to downside the space of its office building, it won’t be able to do so until the lease expires. REITs commonly enjoy 5-10 years remaining on average on their leases. Companies cannot just stop paying rent overnight. It leaves plenty of time for REITs to find new tenants if the current occupant decides to vacate.
The main reason for the bankruptcy of large and successful businesses is probably the evolution of technology and the disruptive impact that it has on markets. All businesses are impacted, but real estate to a much smaller degree.
You cannot replace having a roof over your head and everybody needs to live somewhere. Airbnb (AIRB) may impact hotels, but if you own a good property in a good market with growing demand, you will do just fine. Similarly, if you own a Class A mall in a densely-populated area with growing demographics, you always can adapt to sustain high sales and fight Amazon (AMZN). Note that such properties are today generating higher sales and rents than ever in their history despite the rapid growth of e-commerce.
The point here is that good real estate is extremely durable and has better staying power because it's always in great need. It can adapt to changes and thrive even through technological advancements.
When Sears goes bankrupt, the mall owner can redevelop and release to LA Fitness. When Blockbuster vacates, the space can be released to Subway. You get the point. Business come and go. Real estate is here to stay.
Any single property may always run into trouble. Perhaps the roof might leak and cause costly damage that ruins your returns. Your tenant might vacate and finding a new tenant may take more time than expected. The economic conditions of your city might deteriorate and cause a demographics flux out of it.
These risks are very well diversified by REITs because they typically own 100s, if not 1000s of properties across all markets (Realty Income (O) owns ~6,000 properties). You can then yourself own a portfolio of 10-20 REITs to diversify even further.
Moreover, REITs enjoy today the strongest balance sheets ever in their entire history. The leverage levels are down to just 35% and REITs have ample liquidity to deal with unforeseen events. They learned their lesson from the 2008-2009 subprime crisis and balance sheets are today conservatively structured to provide margin of safety during crises.
Ultimately, the reason why we favor REITs over regular stocks is because we know that they are here to stay. In a recent study, we found that:
“In nearly 4,000 REIT years of operation, only one publicly-traded Equity REIT was forced to declare bankruptcy. So, if you are statistically minded, the odds for any one REIT to fail in any one year are with some factor of 0.025%.”
Bankruptcies simply don’t happen unless the REIT is grossly mismanaged or overleveraged. The same cannot be said about regular businesses (stocks) which are at great risk from new innovations and competitors entering the market. Bankruptcies are much more frequent. In fact, they happen every day.
The superior resilience of REITs also is reflected in their performance during recessions. On average, REITs provided nearly 2x better downside protection than the S&P500 during the average recession over the past three decades. Because REITs did much better during recessions, they also generated higher total returns over the full cycle:
In other words, REITs provided higher total returns with lower business risk. And ultimately, this is why I believe that real estate is the best asset class in the world.
At the end of the day, I'm not smart enough to know whether Apple will still dominate 10 years from now. I cannot predict whether General Motors (GM) will ever recover. And I certainly can’t tell you if Amazon can keep on growing year after year as it does today. The reality is that all these things are unknown to most of us and totally unpredictable. We like to think that we are smart and know what will happen, but in insights most of us would have never predicted what happened over the past 20 years.
REITs provide much better predictability because real estate is a very durable asset that has provided consistent returns to their owners for centuries. At High Yield Landlord, we favor predictability over uncertainty. And income over speculation. We are real estate landlords, not stock market traders.
At High Yield Landlord, We spend 1000s of hours and well over $50,000 per year researching the REIT, MLP and other real estate markets for the most profitable investment opportunities and share the results with you at a tiny fraction of the cost.
This article was written by
Jussi Askola is a former private equity real estate investor with experience working for a +$250 million investment firm in Dallas, Texas; and performing property acquisition in Germany. Today, he is the author of "High Yield Landlord” - the #1 ranked real estate service on Seeking Alpha. Join us for a 2-week free trial and get access to all my highest conviction investment ideas. Click here to learn more!
Jussi is also the President of Leonberg Capital - a value-oriented investment boutique specializing in mispriced real estate securities often trading at high discounts to NAV and excessive yields. In addition to having passed all CFA exams, Jussi holds a BSc in Real Estate Finance from University Nürtingen-Geislingen (Germany) and a BSc in Property Management from University of South Wales (UK). He has authored award-winning academic papers on REIT investing, been featured on numerous financial media outlets, has over 50,000 followers on SeekingAlpha, and built relationships with many top REIT executives.
DISCLAIMER: Jussi Askola is not a Registered Investment Advisor or Financial Planner. The information in his articles and his comments on SeekingAlpha.com or elsewhere is provided for information purposes only. Do your own research or seek the advice of a qualified professional. You are responsible for your own investment decisions. High Yield Landlord is managed by Leonberg Capital.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.