VNO - The More It Drops The More I Buy

2023-03-27 08:05:00 ET

Summary

• REITs are down very significantly over the past weeks.
• We continue to execute our accumulation strategy.
• Here we highlight some REITs that what we have been buying lately.

REITs ( VNQ ) surged in early 2022 as investors began to see the light at the end of the tunnel. Inflation began to cool off and the bond market was quick to price lower interest rates. This led to an epic rally with lots of REITs rising by 15-20% in just a few weeks:

But then Jerome Powell reminded investors that inflation is still here and more rate hikes are needed to make sure that we don't end up with persistently high inflation. This triggered a sell-off across the entire stock market, but REITs dropped even more than the rest because they had risen so much earlier this year. On average, REITs dropped by 17% and many of the smaller and more volatile names dropped by 50% or more:

Just to give you a few examples... SL Green ( SLG ), Vornado Realty Trust ( VNO ), and Uniti Group (UNIT) all dropped by over 50% in just over one month!

What do I make of it?

If you have read my work for a while, you will probably know my reaction to market volatility. I embrace it because it results in great long-term buying opportunities.

The value of the underlying real estate or the long-term trajectory of its cash flow has not changed materially in most cases over the past month, but its price is now lower, much lower through the REIT market.

We think that this is ultimately just another temporary setback and we are taking advantage of it to accumulate larger positions in select REITs at bargain valuations.

It is thanks to this simple philosophy that we earned huge returns in 2020 and 2021 as the market recovered, and despite suffering losses in 2022, we are still well ahead of market averages (You can read our latest performance review by clicking here ).

The recent uncertainty may feel unprecedented but the reality is that we have gone through much worse and the market has always eventually recovered and reached new highs. Here is an interesting quote from Warren Buffett:

In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

REITs have always eventually recovered, 100% of the time , from every previous market crash. Volatility comes and goes, but good real estate always eventually recovers and reaches new highs:

And beyond that, REITs have always been exceptionally rewarding in the periods following sharp sell-offs.

REITs nearly tripled in the two years following the crash of the great financial crisis:

They also more than doubled in the year following the covid crash:

Today, the market conditions are reminiscent of 2008 , with REITs heavily discounted and offering the potential for substantial returns in the years ahead:

Therefore, I am actually glad that the market is crashing again. Seeing red color never feels pleasant at the moment, but looking back, we have always earned our largest gains coming out of bear markets.

The market is at its most inefficient when it is volatile and that's really when active investing is also the most rewarding.

Of course, we don't have a crystal ball and cannot know how the REIT market will perform in the short run, but historically, those who have had the courage to buy REITs when they were temporarily discounted have always been richly rewarded in the following years.

Here are 6 reasons why this time won't be different:

• Reason #1: REITs are heavily discounted: A recent study by Janus Henderson found that REITs are priced at a 28% discount to their NAV on average. The ultimate proof that REITs are today discounted is the fact that REIT capital offerings are down 93% year-to-date. REITs have simply stopped selling equity because their shares are too cheap. This means that we get to buy good real estate that's professionally managed at a large discount to its fair value. In some cases, we pay as little as 30 cents on the dollar for high-quality real estate that's diversified, liquid, and professionally managed (e.g. Vonovia $ VONOY ).

• Reason #2: REITs own inflation-protected assets: We are not making any more land and good buildings in attractive locations only grow in demand over time. Moreover, building materials and labor are only getting more expensive, which increases the replacement cost of existing properties. This makes real estate (and REITs) one of the best inflation hedges in the world. Today, most construction activity has been put on a halt because the surge in inflation and interest rates has made it too expensive to build. Ongoing projects are being finished, but other ones are put on pause. This bodes well for future rent growth.

• Reason #3: REIT debt is being inflated away: While property values will keep growing over time, the value of the debt is permanently inflated away in today's environment. Most REITs have financed their properties with fixed-rate long-term debt and therefore, the high inflation is a gift to them. When a REIT borrows $100, it still only needs to pay back $100 years later even as this $100 is now worth a lot less.

• Reason #4: REITs are not materially impacted by rising rates: Contrary to what you often hear, REITs have historically been strong performers during times of rising interest rates. That's because rising rates are typically the result of economic growth and/or inflation, both of which are very beneficial for REITs, and since REITs use fixed-rate long-dated debt, the negative impact of rate hikes is limited. This time around, interest rates have surged very rapidly and it is causing investors to panic, but it should also be noted that REIT balance sheets are the strongest they have ever been and inflation is exceptionally high. This explains why REIT cash flows grew rapidly in 2022 and are expected to keep growing in 2023 in most property sectors. What about property values? We think that a crash is unlikely due to a number of reasons that we discuss in a separate article that you can read by clicking here.

• Reason #5: Most REITs are recession-proof: Most REITs are relatively resilient to recessions because they generate income from multi-year leases. Moreover, having a roof over your head is a basic necessity that does not simply disappear in a recession. Sure you may not need quite as much real estate during a recession, but you will need an apartment to sleep in, a place to work, a grocery store to buy food, farmland to grow the food, cell towers for communication, warehouses to store goods, etc. Consumers and businesses typically don't completely rethink their real estate footprint just because the economy is taking a dip for a year or two. For this reason, REITs have historically outperformed most other sectors during recessions. Long-term leases also provide additional security and cash flow stability.

• Reason #6: Private equity is buying REITs left and right: Right now, private equity players like Blackstone ( BX ) are flushed with cash and they are buying REITs left and right. Blackstone bought out $30 billion worth of REITs in 2022 and it recently noted in its conference call that they are looking for more buyout opportunities because they think that REITs are materially discounted relative to the underlying value of its real estate. Since making that statement, REITs have dropped another 10%. Brookfield ( BAM ) is also acquiring a lot of REITs, but mainly in Europe so far.

It is easy to get distracted by the negative news and get emotional when volatility is high, but you really don't need to be a rocket scientist to understand that buying good real estate at a heavily discounted price will result in attractive returns in the long run. Sure, an occasional crisis may lead to worse results for a year or two, but the impact on the fair value of income-producing real estate should be limited because its value should be determined based on decades of expected future cash flow.

Yet, REITs commonly drop a lot at the first sign of uncertainty because most market participants are focused on short-term results and lack the discipline to hold for the long run.

Warren Buffett has famously said that " investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ. " However, you need to have the discipline to hold when volatility is high and have the courage to step up and actually make purchases when opportunities are abundant. Interestingly, Warren Buffett has deployed a considerable portion of Berkshire Hathaway ( BRK.B )'s cash pile over the past year:

Will prices keep dipping lower? Is it too early to buy? Or have we hit bottom?

We get these questions all the time at the moment and unfortunately, we don't have answers for you. A lot of investors pretend to know the answers, but we firmly believe that nobody really knows. Again, here's what Warren Buffett would answer:

"We've long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children."

You must feel comfortable with this reality. We cannot predict short-term results. If we could, we would all be billionaires.

What we can do however is forecast the expected return potential based on fundamentals and valuations over a multi-year holding period. And right now, there are lots of opportunities in the REIT sector that are priced to deliver very strong returns.

Therefore, now is the time to step up and start adding to our positions and the best approach remains to accumulate shares in many phases. By buying a little each week, we take emotions out of investing and maintain a consistent and disciplined approach that has always paid off in the long run.

Below we share some of our latest transactions:

• Tricon ( TCN ): We recently bought another 130 shares, increasing the size of our position by 13%. We recently initiated a position in the company because we see it as a way to gain exposure to a portfolio of single-family houses in strong sunbelt markets at a large discount to their fair value. Nothing major has changed, but its share price has kept dipping lower and as a result, the company is now priced at an estimated 40% discount to its net asset value. That's the lowest valuation ever for the company. Rents continue to grow at a good pace and the company has great long-term growth prospects in asset management. I recently got to listen to the CEO talk at the Citi Global Property Conference and he seems very optimistic. We expect 50%+ upside to fair value.

• BSR REIT ( BSRTF / HOM.U:CA ): We recently bought another 80 shares, increasing the size of our position by 4%. BSR is an apartment REIT that specializes in rapidly growing Texan markets. They recently reported results and the main takeaway was that their NAV per share remains resilient at around $22 per share, and yet, its shares continue to trade at a huge discount at just around $13. Rents also keep growing steadily, the management is buying back shares, and a new dividend hike will likely be announced in the coming months. We expect 50%+ upside as the share price eventually recovers closer to its NAV and you earn a 4% dividend yield while you wait. The management told us in a recent exclusive interview that they expect to keep buying back more shares as long as they trade at such a low valuation.

For further details see: