VNQ - Forget Bonds Buy REITs

2023-11-09 08:05:00 ET

Summary

• REITs are often seen as "bond alternatives."
• But they really aren't.
• I expect REITs to earn far higher returns over time. Here's why.

Co-produced by Austin Rogers,

Real estate investment trusts ( VNQ , "REITs") are often seen as "bond alternatives" because of their relatively high dividend yields. REITs have to pay out at least 90% of their taxable income (not the same as their cash flow) as dividends, making them a go-to investment for passive income seekers.

During the 2010s and into the early 2020s, interest rates and thus bond yields hovered in the low- to mid-single-digits, making them increasingly unattractive for income investors. Hence the burgeoning popularity of REITs as alternative sources of income.

But there's a lot more to REITs than just their dividend yields. They own real, scarce assets that can increase in value over time and generate growing rental revenue, thereby providing inflation protection and upside. And they have professional management teams whose interests are usually well-aligned with shareholders.

Even with investment-grade corporate bond yields reaching 6-7%, we still think it is a good idea for long-term income investors to favor REITs over corporate bonds right now.

Let us explain why.

Why REITs Beat Bonds In The Long Run

There are several fundamental differences between REITs and bonds.

Bonds are fixed-income investments. They are debt securities issued by corporations or governments that pay a fixed coupon for a predetermined period of time, ending at the maturity date. Upon the maturity date, bondholders receive the face value of the bond back to them in cash.

REITs, on the other hand, are equity investments. They are ownership stakes in businesses, just like any other stock. As long as REITs have positive taxable income, they are required to pay a dividend, and most REITs pay out 50-90% of their cash flows. Depending on the valuation awarded to the REIT by the market, REITs offer dividend yields anywhere from about 2.5% on the low end to over 10% on the high end.

With bonds, returns are very well defined. You get a fixed coupon and the promise of receiving the face value of the bond at the maturity date. If you buy the bond at a price below its face value, you will receive return on your investment equal to the difference between your purchase price and the face value.

These are the only two sources of returns for bondholders: the fixed-rate coupon and any upside to face value from your purchase price.

REITs, on the other hand, come with all the risks, rewards, and complexities of any other ownership stake in a real business. That's why we insist upon investing in REITs with a landlord's mindset, not a trading mentality.

Sure, corporate bonds are higher in the capital stack, and therefore bondholders would be paid first before stockholders in a worst-case/restructuring scenario. But unless one is investing in highly risky companies, this point usually does not matter.

The vast majority of the time, for REITs with investment-grade credit ratings, both the dividends for stockholders and the coupons for bondholders are safe and reliable.

There are two basic reasons we think long-term income investors should favor select REITs over bonds:

1. REITs enjoy more sources of potential upside than bonds
2. REITs offer inflation protection through growing dividends, whereas bonds offer only fixed coupons.

Let's address each point.

1. REITs Have Greater Upside Potential

Bonds have lower volatility than REITs (or other stocks, for that matter), so it is not surprising to see that corporate bonds, as measured below by the iShares iBoxx $ Investment Grade Corporate Bond ETF ( LQD ), have sold off less than REITs, measured below by the Vanguard Real Estate ETF ( VNQ ), since the peak in stock prices and trough in bond yields at the beginning of 2022.

But REITs enjoy far greater upside and total return potential going forward than bonds. There are multiple reasons for this.

First and most obviously, REITs have already sold off heavily, shedding over 1/3rd of their collective market cap since the beginning of 2022. Their valuations have been marked down as interest rates have climbed. But if interest rates eventually reverse and go lower (which may already be happening), REIT performance should reverse: outperforming bonds as rates fall, just as they have underperformed bonds as rates rise.

Second, remember that REITs are real businesses that own real properties. Land is inherently scarce, and they aren't making any more of it. And while developers have a wave of new supply of buildings scheduled for delivery over the next year or so, high interest rates have caused new construction starts to plummet this year. This should create a supply-demand balance heavily in favor of landlords in 2025 and beyond.

Third, as a result of the second point, REITs should enjoy asset appreciation and rental revenue growth going forward, which should in turn translate into rising EBITDA and cash flows.

In short, then, while bonds really only have one source of potential upside (falling interest rates), REITs have several.

That is why we see REITs massively outperforming corporate bonds over long periods of time:

Keep in mind that BBB corporate bond yields are higher today than when the above chart begins in late 2004, and LQD's price is lower today than it was then. So, the sole source of the total returns you see in the above chart is coupon income.

Whereas for REITs, the VNQ's price is up ~50% since late 2004, even though it trades over 30% below its all-time high. As such, REITs' upside has clearly come from both stock price appreciation and growing dividends.

2. REITs Offer Inflation Protection From Dividend Growth

A common mistake investors make is forgetting to account for inflation. Nominal returns are a useful shorthand, but real returns (subtracting inflation from nominal returns) are ultimately what investors, especially income investors, should worry about.

Because of the combination of factors above, especially tenant demand for space outpacing real estate supply, REITs have a very strong and extended track record of growing rental revenue, EBITDA, and cash flows -- or funds from operations ("FFO"). This has allowed them to grow their dividends over time at a faster pace than inflation.

On the other hand, bonds pay only fixed-rate coupons that do not rise over time, causing the real (inflation-adjusted) value of bonds' income streams to decline over time.

As prices rise, the fixed coupon of a bond you bought many years ago has less purchasing power today than it did when you first bought the bond. This is true whether you bought the bond at a 3% yield or a 7% yield.

Since the end of the Great Recession in 2009, REIT dividends have beaten inflation, while bond income has fallen in both a nominal and real sense.

This is true whether you invested in a bond fund like LQD or individual bonds, rolling them over as they matured.

And by the way, investors who wisely picked individual REITs have seen far greater dividend income growth over time than the VNQ. The above chart shows one reason why we don't invest in REIT ETFs, preferring instead to cherry pick the best and most opportunistic names.

Take, for example, the dividend growth of three high-quality, blue-chip REITs since the Great Recession, all beating inflation by a wide margin:

These three REITs all own different types of real estate.

Alexandria Real Estate Equities ( ARE ) owns Class A life science buildings in top research markets across the US. Mid-America Apartment Communities ( MAA ) owns apartment communities in fast-growing Sunbelt states. And Realty Income ( O ) owns a diversified portfolio of high-quality triple net lease properties across the U.S. and Western Europe.

Yes, it is true that we are cherry-picking some of the best performers since the GFC here. But there are many other REITs with similar dividend growth records. We point these out simply to show the possibility that a portfolio of intelligently selected REITs can offer generous starting yields and inflation-crushing dividend growth.

We think that is vastly preferable to bonds that see the real value of their coupon income decline over time amid rising consumer prices.

Bottom Line

There's nothing wrong with seeking safe sources of income. We simply think that selectively chosen REITs are generally a better source of passive income than bonds. They offer more potential upside as well as inflation protection via dividend income.

We think it is generally smart for investors to keep an emergency fund of cash and short-term bonds equal to anywhere from 3 months to 2 years or more of living expenses, depending on one's age, employment status, health, and so on.

But for any money that investors will not need back anytime in the next few years, we believe REITs are the vastly superior long-term investment to bonds.

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