There Might Not Be Another Chance Like This For Years
Summary
- REITs have strongly recovered over the past months and it's causing investors to pause.
- I think that we're still in the early stage of a multi-year repricing that will push REIT valuations to new historic highs.
- There's no other alternative for income-seeking investors in today's yieldless world.
- Looking for a portfolio of ideas like this one? Members of High Yield Landlord get exclusive access to our model portfolio. Learn More »
Right now, one of my most frequently received questions is whether it's too late to invest in REITs?
REITs (VNQ) have appreciated by ~70% over the past year, and understandably, it's causing some investors to pause.
Generally, you would want to buy things shortly after they have collapsed, and not the other way around.
Even then, I still have more than half of my net worth invested in the REITs presented at High Yield Landlord and have no plans of bringing that allocation down.
I continue to believe that REITs present a historic opportunity and this recent appreciation is just the beginning of a multi-year repricing that will push REITs valuations to levels that we have never seen previously.
To understand why we need to first look at the broader financial market.
Treasuries, Bonds, Stocks, And Alternatives
Today, investors have four main options when investing their capital:
Option #1: They can buy Treasuries
Option #2: They can buy corporate bonds
Option #3: They can buy stocks
Option #4: They can invest in alternatives such as REITs
Treasuries are of course the safest option of all. They are backed by the full faith of the US government, but because of that, they're also the lowest returning investment. Currently, the 10-year Treasury is just 1.7%, which is barely enough to cover today's inflation and taxes. In fact, inflation-protected Treasuries, or TIPs in short, already have a negative yield.
Earning 0% returns is not sustainable, and therefore, many investors have been forced up the risk ladder and replaced Treasuries with corporate bonds.
As a result, their yields have also compressed to historically low levels. The Vanguard Long-term Corporate Bond ETF (VCLT) has a 3.3% yield, and to earn that, you need to accept credit risk.
Today, a lot of companies are just shy of losing their investment-grade credit rating due to losses caused by the pandemic, and this will likely hurt the returns of corporate bond funds in the coming years.
Again, after inflation, taxes, and credit losses, the returns are near-0%:
If you cannot earn adequate returns from Treasuries or bonds, then the logical next option is to invest in stocks.
And that's what most investors have done. They have been forced to reduce their exposure to fixed-income investments and replaced them with more equities, which has pushed valuations to levels rarely seen before.
Based on the dividend yield of the S&P 500 (SPY), stocks are today priced at richer levels than any time before, at the only exception of the dot-com bubble:
And based on the P/E ratio, the S&P 500 is currently priced at 40x earnings, which is more than double of its historical median:
You will note from the above chart that such high valuations have never been sustainable in the long run. They always eventually come crashing down to more reasonable levels.
Will this time be different?
Maybe.
But it's fair to say that the future prospects don't look very promising. Investors are accepting a lot of risks to earn mediocre returns at best, or to suffer large losses at worst.
Ray Dalio and Jeremy Grantham warn us of a possible "lost decade," which implies that returns could be near-0% as valuation multiples compress all while growth stagnates in the recovery of the pandemic.
You may dismiss it as "fear-mongering," but "lost decades" are actually more common than you may think:
With that in mind, we are not just in a "low return environment," we're quite possibly in a "zero return environment." Even if you don't buy into that, you would admit that we are in an "ultra-low yield environment."
Yet, investors need returns and many absolutely need income to survive.
Think about all the pension funds, retirees, insurance companies, banks, endowment funds, and sovereign funds that cannot function without income.
If they cannot earn their needed income from stocks, bonds, or treasuries, where else will they invest?
Here comes the last option: Alternatives.
Today, alternatives are hotter than ever before, and this is only the beginning. Think about housing, renewable energy, timberland, Bitcoin (BTC-USD), etc.
These are all sectors that still offer attractive total return potential in a world of near-0% returns.
Real assets are particularly attractive because they generate a lot of income and protect against inflation, which is precisely what investors need in today's yieldless, money-printing world.
And as investors increase their allocations to real assets, you will see their valuations rise, their yields compress, and that's why we are so bullish on REITs. They're still priced at a discount to pre-pandemic valuations, which already were discounted relative to where we think that we are going.
Let's take a closer look at Germany:
The Case Study of Germany: Impact of Sustained Low Rates on Real Assets
Over the past 10 years, I have gotten to live and work in the real estate field in both, Germany and the US.
The contrast is very interesting because Germany has had near-0% or even negative interest rates for years already, whereas the US is still years behind and now slowly going into a similar environment.
With rates at such low levels, investors in Germany have loaded up on real estate and pushed cap rates to levels never seen previously. If you want to buy high-quality real estate in cities like Munich, it's not uncommon to pay as low as 2%-3% cap rates, despite not enjoying particularly good growth prospects.
So far in the US, you have gotten double of that and the growth has been even stronger.
But now as the US goes into an extended period of near-0% interest rates (and the Fed already confirmed this), we expect the same cap rate compression to happen in the US.
Cap rates will drift much lower which will increase property values as well as REIT NAVs.
It is precisely what billionaire investor Bruce Flatt has been saying in recent interviews.
Here's what he recently said on the expected impact of low interest rates on real estate:
"The repricing of real estate has not even started yet... Right now, assets are not trading because people are not comfortable. Even if you have a building that is let for 20 years, people are confused by what that really means. But once this clears, and interest rates are at a new low, cap rates will start coming down, and valuations will go way up.
A cap rate in a city center office building might have been 4% before, and it's probably going to 2%. If we are in a 0% interest rate world and people believe that we will be in a 0% interest rate world for a while, and the Fed has told you that, then I see no reason for a long-tailed asset with 20 years of cash flows not to be at around 2%.
If that building was selling at a 4% cap rate prior to the pandemic and fetched $1 billion, it would fetch north of $2 billion at a 2% cap rate. That's one billion profit."
And here's what he said on REITs in relation to that:
"Probably the greatest discount out there between what you would see as value and price is in REITs and real estate securities.
REITs that have high quality assets trade at enormous discounts to the tangible value of their assets, let alone if we are right in what I just said earlier about the repricing."
That's The Historic Opportunity
Bruce Flatt runs Brookfield (BAM), which is a global private equity firm, and he has seen the impact of low interest rates on real assets in places like Germany.
The same repricing will now happen in the US.
Because investors have no other alternatives, Brookfield expects allocations to real assets to rise from 25% to 60%-plus over the coming decade:
Investors simply don't have any other alternatives to earn much-needed income in today's world.
And as all these trillions of dollars come chasing a limited number of assets, cap rates will compress (just like in Germany) and valuations will expand.
Those who invest in REITs today are still catching the wave early because valuations remain discounted relative to where they were prior to the pandemic when interest rates were much higher.
Now is possibly your last chance to buy high-quality REITs at 4%-6% dividend yields because these yield levels won't last in a yieldless world.
I'm putting my money where my mouth is and recently doubled down on some of my favorite opportunities.
Now is not too late to invest in REITs, but it may soon be.
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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.
Analyst’s Disclosure: I am/we are long BAM. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (297)
For example the company I work for (a software company) has not renewed any of its office leases, and to my knowledge, this is happening all across the country. Going into work at an office is a complete waste of time and money. I would never again work for a company that requires me to commute an office and I think a lot of people feel the way. So goodby to office spaces, unless maybe offices are converted into condos. That might be a real growth opportunity. What do you think?Also what is this "cap rate" you've mentioned so many times? I've never come across that terminology.
There’s this thing called performance chasing...
You forgot ARKK and EVs by the way.
Yes, REITs are definitely a different beast from other stock classes: here it is counterproductive to try to pick up the one with the best product and best growth perspective and profitability. The product is pretty much the same for every equity REIT, that means the biggest ones will always have a competitive advantage towards the mid cap or the small ones.
Thanks for your article. I appreciate your articles and I appreciate your willingness to respond to the many comments to your articles. I am a follower!
I am now a retired investor, 64 years old. I have not owned many REITs in the past but have started to be more interested in having income generating investments since retiring at 63. I bought IIPR in Q4 2019 and have added more shares in Q2 2020. My avg cost is ~$72. In addition to the nice increasing dividends (currently $1.32 per qtr), the stock has appreciated to $183 as of the close today and has been as high as $220. I sold $210 covered calls for $7.50, got called out and bought back the next week at $203. In my Roth IRA account so all dividends are tax free. I have a similar experience in SPG bought in Q3 2020 which now pays $1.30 in qtrly dividends and has almost doubled since I bought it at $64. purchased in IRA account so dividends for my SPG is tax deferred. Fellow SA readers, REITS belong in your portfolio and should not be overlooked as part of your balanced portfolio. Do your due diligence and pick good ones. Jussi is someone you should “follow”. I look forward to his articles and thoughtful guidance/ advice.
Do you think it is - the geographical aspect is not important in my question- reasonable to invest in non-REIT real estate stocks? To be honest I would personally be happier to invest in real estate that does not even pay a dividend. VNNVF offers a stock dividend as an option for example.I would be interested what you think about it, considering you just talked about REITS and not real estate companies using diffrent "legal framework".
The killing of the 1031 exchange will stop the trading up on assets.
The 44% capital gains tax, will chill the market.
Good companies and good real estate Un leveraged will be the holding pattern.
I assume we will look like the EU in 2 years.
My biggest fear is NYS rent control hitting commercial.
2) Removing the 1031 gives REITs a competitive advantage and lowers competition from private investors. REITs pay no corporate tax.
3) REIT balance sheets are stronger than ever at below 40% LTV on average.
4) If the US looks like the EU in two years, that would mean that the US has significant upside from here. Cap rates are much lower in Europe.
