- The REIT market has officially recovered from the pandemic.
- Despite that, we think that REITs still have a long way to go and remain undervalued.
- We demonstrate this by comparing REITs to other major asset classes.
- Looking for a portfolio of ideas like this one? Members of High Yield Landlord get exclusive access to our model portfolio. Learn More »
The REIT (VNQ) market has now fully recovered from the COVID crash and increasingly many investors are asking themselves:
Is it time to sell?
My answer is a clear no.
I still have about 50% of my net worth invested in the REITs presented at High Yield Landlord and have no intentions of selling any time soon.
I strongly believe that this is just the beginning of a multi-year repricing that will push REIT share prices to new all-time highs and REIT dividend yields to new all-time lows.
This is because relatively speaking REITs continue to offer exceptionally good value and yield in today's yield-less world. Below, we look at the broader financial market and compare REITs to other major asset classes that are competing for investor's capital.
REITs vs. Treasuries, Bonds, and Stocks
Everything is "relative" in finance.
You invest in something because it's a better opportunity relative to something else. But if that something else suddenly becomes more attractive, you may need to reconsider your investment decision.
Right now, investors have four main investment options:
- 1) You could invest in Treasuries
- 2) You could invest in bonds
- 3) You can buy stocks
- 4) Or finally, you can invest in alternatives (to which REITs belong)
Let's review each one by one:
Treasuries are the safest investments from the perspective of credit losses because they are backed by the full faith of the government.
But what are you getting from them?
Right now, the 10-year Treasury (IEF) yields 1.65%, and the 30-year Treasury yields only slightly more at 2.3%.
These are the lowest yields in decades:
If you deduct taxes and inflation, the yield is today negative. In fact, Treasury inflation-protected securities, or TIPS, in short, have a negative yield at the moment.
As such, when you invest in Treasuries, you accept a negative real return, which isn't sustainable for the great majority of investors.
Therefore, investors are left with three options: Bonds, stocks, and alternatives.
Bonds are similar to Treasuries, but instead of lending money to the government, you are lending it to companies, which introduces credit risk to the equation.
Companies come and go and a promise of repayment means little if the company goes bankrupt. You may mitigate this risk by investing in bonds of investment-grade rated companies, but then your yield goes down, and credit ratings can vary over time. According to the S&P, nearly half of A-rated companies can expect to lose their investment-grade rating over a 10-year time period. For lower ratings, the likelihood is even greater.
With that in mind, you need to get compensated for the additional credit risk because credit losses are inevitable when lending money to businesses.
Today, the average yield on long-term corporate bonds (VCLT) is roughly 3.2%:
So you are getting a 100 basis point spread relative to 30-year Treasuries to compensate you for the risk of credit losses, which will occur as companies go bankrupt or lose their investment-grade rating and bonds lose value.
That's a historically small spread, especially in the midst of a severe crisis that has hurt a lot of companies.
if you remove 1/3 to taxes and another 1.5% to inflation, you are left with 0.6% to compensate you for the credit risk. And that's assuming the inflation won't get out of hand over the coming decades because if it does, your real returns would quickly turn negative.
Alright, so Treasuries and bonds aren't sustainable investments in today's yield-less world for most investors.
That leaves us with stocks and alternatives.
Warren Buffett has famously said that interest rates are basically to the value of assets what gravity is to matter.
With interest rates set in the 0 to 0.25% range by the Fed, investors have been forced into stock investments to seek higher returns.
But what happens when you have an increasingly large amount of demand for stocks, which are limited in supply?
Simple laws of supply and demand would push prices higher and that's exactly what has happened. The S&P 500 (SPY) has nearly quadrupled (!!!) over the past 10 years:
Clearly, these rates of return are not sustainable. They're the result of expanding valuation multiples, which cannot keep expanding forever.
Right now, the P/E multiple of the S&P 500 (SPY) is 42x, which is more than twice its historic median, and comparable to the dotcom bubble:
If you look at the above chart, you will note that the stock market has never been able to sustain such high valuations for long. Eventually, the multiple contracts closer to historic norms, leading to large losses, which we haven't had for a long time.
In fact, the S&P 500 is up very substantially since the beginning of the pandemic, which everyone would agree is rather strange.
That's the power of 0% interest rates!
If Treasuries and bonds provide a negative real return, then paying 42x for the broader stock market becomes a great alternative, even despite the pandemic.
At least you will enjoy growth in earnings in the long run, which should support a mid-single-digit total return.
Now, let's look at alternatives like REITs, and you will understand why they remain undervalued.
Today, REITs are barely getting back to where they traded before the pandemic.
But the big difference between then and today is interest rates.
Back then, interest rates were set at 2.5%. Today, they're down to 0%:
Just like how the market repriced stocks at materially higher levels due to the 0% interest rates, we expect REITs to reprice at much higher levels as well.
So far, we have only seen a recovery from the Covid crash, but the repricing to the lower interest rates is yet to happen.
Why is that?
The repricing was delayed by temporary fears that are specific to REITs.
These are all fair concerns.
But what the market appears to have missed is that only ~10% of REITs invest in these property sectors.
The great majority of REITs invest in more defensive sectors that haven't felt much, if any, pain from the pandemic. Many sectors even benefit from it:
- E-commerce warehouses
- Data centers
- Cell towers
- Manufactured housing
- Single-family rentals
- Net lease properties
- Life science labs
We always talk about the pain caused by the pandemic, but the reality is that there are more property sectors that actually benefited from it. Most REITs invest in these sectors, and therefore, the recent recovery is well justified.
But despite the recovery, valuations remain exceptionally low when compared to Treasuries, Bonds, and Stocks:
Historically, the valuation spread has been much smaller, but because the S&P 500 already repriced to the lower yield world, the spread has grown significantly.
Is 16x FFO a reasonable valuation for REITs in a 0% interest rate world?
No, it isn't.
If you look at Germany, which has had ultra-low interest rates for years already, it's not uncommon for REITs to trade at closer to ~30x FFO and ~2% dividend yields.
I think that's where we are also going in the US, but we're just a few years behind in this repricing.
So if you feel like you missed out on the gains of the S&P 500 as it repriced for the lower yield world, you are given a second chance with REITs.
They are still early in the repricing. In fact, they just barely recovered from the losses and will now begin the repricing to lower interest rates.
We remain net buyers, but have become more selective. We invest in the REITs with the most upside potential in a yield-compressing world.
If you want full access to our Portfolio and all our current Top Picks, feel free to join us for a 2-week free trial at High Yield Landlord.
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This article was written by
Jussi Askola is the President of Leonberg Capital, a value-oriented investment boutique that consults hedge funds, family offices, and private equity firms on REIT investing. He has authored award-winning academic papers on REIT investing, has passed all three CFA exams, and has built relationships with many top REIT executives.He is the leader of the investing group High Yield Landlord, where he shares his real-money REIT portfolio and transactions in real-time. Features of the group include: three portfolios (core, retirement, international), buy/sell alerts, and a chat room with direct access to Jussi and his team of analysts to ask questions. Learn more.
Analyst’s 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.
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