I have been in real estate quite literally my entire life.
I was born into a family of real estate professionals. We moved to France when I was 5 due to my father's real estate ventures, and I grew up visiting countless construction sites with him. Eventually, I went to university to study Finance with a specialization in commercial real estate and bought my first property at just 19 years old.
A few years later, I landed my first job in private equity real estate. We would acquire mostly net lease properties such as those of Realty Income (O) but also had a few land development projects and some residential investments.
So I thought that I was on track to make it big in real estate. I had the ideal background, education, and experience, and I was truly passionate about it.
However, I have completely stopped buying real estate. I bought my last property during the pandemic, and since then, nothing.
I have completely turned away from traditional real estate investments and there is one main reason for it.
I believe that publicly listed REITs offer far better risk-to-hassle-adjusted returns in most cases in today's environment.
I am going to explain to you why, but we need to first start with some basics.
REITs stands for Real Estate Investment Trusts. They are investment vehicles that pool capital together and then make real estate investments. As such, they allow you to participate in the returns of real estate without having to actually go out and buy properties yourself.
This comes with pros and cons.
The main advantages are that you enjoy:
- Diversification
- Professional management
- Liquidity
- Economies of scale
- Limited liability.
But there are a few downsides relative to private real estate as well:
- Typically, REITs use less leverage than private real estate
- And they may be more expensive than private real estate.
As such, it has historically made sense to invest in both. In my case, REITs would build the base of my portfolio, and I would then complete that with more concentrated and riskier private real estate investments.
But today, it makes no sense to buy private real estate because:
- Interest rates are today a lot higher for private real estate and it does not make sense to use much debt.
- Valuations are today also a lot higher for private real estate than for REITs.
And so why would anyone want to buy private real estate instead of REITs?
When you buy shares of a REIT, you get all the benefits we mentioned earlier, and then on top of that, you also enjoy the benefits of much cheaper debt and lower valuations in today's environment.
Let's look at an example to illustrate this point:
If today, you wanted to buy an apartment community in Texas, you would likely get a 5% cap rate, or at most, a 5.5% cap rate. Then your bank would likely ask for a 6-7% interest rate on your mortgage, meaning that you won't be able to use much leverage since you would end up with negative cash flow otherwise. That investment may still produce relatively good returns over time as rents keep growing and your property gains value over the long run. It could get you to high-single-digit or low-double-digit total returns when accounting for the leverage.
But compare that now to buying shares of a sunbelt-focused apartment REIT like Camden Property Trust (CPT).
The REIT has seen its share price crash over the past year even as its cash flows kept on growing and as a result, it is today priced at a near 6.5% implied cap rate. Put differently, it is priced at a 35% discount relative to its net asset value.
Moreover, the REIT secured a lot of long-term fixed-rate debt in the years preceding the recent surge in interest rates, and as a result, its debt has today a 7-year average term with limited near-term maturities and its average interest rate is just 4.2%. This means that you get the benefits of this much cheaper debt when you invest in the shares of the REIT. It is similar to buying a private property and assuming its debt. If that debt has good terms and a low interest rate, it increases the value of the property, but in this case, we are not paying anything for it. On the contrary, the REIT is heavily discounted relative to the value of its properties despite giving you access to cheaper debt.
The cash flow yield of the shares (or its FFO yield as we call it in the REIT world) is today 7.5% when you account for the impact of the leverage and this is also net of all management cost. Out of this 7.5%, the REIT pays 4.1% in the form of dividends, and it retains the remaining 3.4% to reinvest in growth, which will lead to growing cash flow and an appreciating share price over the long run. This is also more tax efficient for shareholders because whatever the REIT retains is fully tax-deferred since REITs pay no taxes.
And it gets better. I would also expect CPT to grow its cash flow at a faster pace than the private property over time because CPT enjoys huge economies of scale, and professional management, and it owns better assets that were built in-house in a way that should minimize capex requirements over time.
If CPT earns a 7.5% cash flow yield and can grow its cash flow by 3-5% annually on average over time, you will easily get to double-digit total returns and that does not even count any upside yet.
Historically, REITs like CPT have traded at a premium to their net asset values during most times. This is how it should be given that they give you so many additional benefits (diversification, liquidity, professional management, limited liability, economies of scale, etc.).
But today, CPT is priced at just 0.65x of its net asset value because the REIT market has crashed in recent years even as private property values remained much more stable:
Historically, whenever we see such huge discrepancies between the valuations of REITs and private real estate, REITs outperform in the following years and earn much greater returns in the following years as they recover.
According to a study by the investment firm Janus & Henderson, REITs have historically earned a ~90% total return in the 3 years following periods when they were priced at a >20% discount to their net asset value:
Today, CPT is even cheaper than that.
Just to return to its net asset value, its share price would need to appreciate by ~50% and you then get the yield and the growth on top of that.
So once again, why would anyone want to buy private real estate?
Option A: You buy a private, illiquid, concentrated asset at a 5% cap rate and need to finance it with a 6.5% interest rate.
Option B: You buy a public, liquid, diversified asset at a 6.5% implied cap rate and you enjoy the benefits of its cheap debt that it has locked in for many years to come.
I would pick the Option B any day of the week.
The risk-to-reward is just a lot better and that is why I stopped buying private real estate.
And you don't need to take it just from me.
Even the big private equity groups like Blackstone (BX) and Starwood have turned to REITs ever since their share prices crashed and they became cheaper than private real estate.
Blackstone has bought $30 billion worth of REITs in recent years and just recently, they bought yet another REIT (TCN) in a multi-billion-dollar acquisition a few weeks ago. They are the biggest private equity group in the world and are known for being "opportunistic" with their real estate investments.
Starwood, another major private equity group, has also been buying REITs and their CEO said the following less than a year ago:
"By the way, when credit comes back, you are gonna see REITs take off... There are some unbelievable bargains in REITs. We did the same thing during the pandemic. We bought a dozen stocks all over the world and we had a 70% IRR on that stuff. We are already buying some stuff in the public market..." Barry Sternlicht, CEO/Chairman, Starwood Q3 2023 CNBC Interview.
Their biggest stock investment is Camden Property Trust according to their latest 13F filing.
But there are many similar opportunities in the REIT world.
The point is simply that buying good real estate through the REIT market at a large discount to its fair value, likely near the bottom of the cycle, right before interest rates are cut, is likely to be a good investment idea.
These private equity players are investing heavily in REITs, and so am I.
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