CA - Why I Stopped Buying REITs To Buy Rental Properties Instead

2023-05-13 09:00:00 ET

Summary

• REITs are better investments than rental properties in most cases.
• But there are exceptions.
• I present one instance when I bought a property instead of REITs.

If you have ever read my research here on Seeking Alpha, you would probably know that I am a big proponent of real estate investment trust, or REIT, investing.

I must have written 10+ articles on why I think that REITs are better investments than rental properties for most investors.

To make it short:

• REITs offer higher returns: Studies show that REITs outperform private real estate by 2-4% per year because they enjoy significant economies of scale, have better access to capital, and earn additional profits from other real estate-related businesses.
• With less risk: REITs are liquid public real estate investment vehicles that are well-diversified, professionally managed, conservatively financed, highly scrutinized, and shareholders enjoy limited liability.
• And less hassle: REITs are totally passive and the management is typically very cost-efficient. Rentals, on the other hand, can be very work-intensive and the management cost is extremely high since you don't enjoy economies of scale. If you valued your time at $30 per hour, it simply wouldn't make sense in most cases.

(You can read more about why I generally prefer REITs by clicking here .)

But there are exceptions!

I like to say that REITs offer better risk-and-hassle-adjusted returns than rental properties in most cases , but those three last words often get overlooked.

There are cases when buying a rental property may make more sense and in today's article, I want to highlight one such example.

In late 2021, I reduced or even stopped my monthly REIT purchases to buy a rental property instead.

At that time, REITs had recovered from the pandemic and were priced at new all-time highs.

There were still some opportunities out there for long-term-oriented investors, but overall, share prices were getting near fair value at the time.

On the other hand, I had come across an interesting opportunity in the private market that had three major advantages relative to REITs at the time:

• Larger discount: The property was priced at a large discount relative to my estimate of its fair value. This specific property was particular in that it was still under development and so you had to make your purchase decision based on plans and drawings. Most buyers want to see the end product before making a purchase decision and so this likely explains why the property was underpriced at this stage. I felt comfortable buying early because I was familiar with the site, the developer, and the construction company had a great reputation.

• Ability to create value: I had an opportunity to add value to the property by making a few minor changes. The layout of the home was a bit unusual and this is probably another reason that led to the mispricing of the property. But by removing/moving a few walls, I was able to open up the property and make it a lot more attractive to a larger pool of potential buyers/renters.

• Cheap and abundant leverage: I only had to make a small down payment to the developer during the construction phase of the property, which essentially meant that I would control the property and its upside with very little skin in the game and had no interest expense during the construction phase. As such, the developer gave me great leverage at no cost on the property during the construction phase. When the construction was completed, I would pay the rest of the purchase price, based on yesterday's pre-agreed prices, and I had also pre-agreed to get a mortgage from a bank for most of the purchase price. This allowed me to take on a lot of debt at a time when debt was unusually cheap and it made sense for me since I was underleveraged.

So I pulled the trigger and bought the property...

At this particular time, this property was more attractive than most REIT investment opportunities.

There are three main takeaways here:

Takeaway #1: it does not have to be one or the other

I think that REITs are better investments than rental properties in most cases , but I am objective enough to realize that both have unique advantages, and the best risk-to-reward is likely achieved by combining the two.

Since REITs are more attractive in most cases, that's where most of my capital is going, but I am not ignoring private opportunities.

Takeaway #2: each property and investor is different

Private markets, just like REITs, can be inefficient at times and present exceptional opportunities.

A REIT may be mispriced due to a number of reasons, and the same applies to private properties. In this case, the property was underpriced likely because it was still in its construction phase and it had a complex layout that needed some creative thinking.

I happened to come across this property, and my knowledge of the market and private equity background allowed me to rapidly see the opportunity.

Had I not had this skill and knowledge, I would have missed it. So your results will largely depend on your skill, knowledge, and personal preferences.

Takeaway #3: valuation is an important factor to consider

There are times when REITs are undervalued.

Then there are other times when they are fairly valued.

And finally, there are times when they become overvalued.

Therefore, it also depends on when you invest.

Back in late 2021, REITs were getting near their fair value, and so I would still favor REITs in most cases, but it was less obvious than in 2020 when REITs were severely discounted.

As a reminder, REITs were priced at large discounts to their net asset value in early 2020, but they then doubled in value in the following year as they recovered:

Today, REITs are again heavily discounted.

According to Janus & Henderson, REITs are currently priced at a 28% discount to their net asset value on average. What this essentially means is that you get to buy an equity stake in the properties of these REITs at just 72 cents on the dollar and you then get the added benefits of liquidity, professional management, and diversification on top of that.

So to make a rental property investment worthwhile, you would need to find one that's priced at an even larger discount to make up for the greater risk and effort.

Besides, the 28% discount is just the average. Many individual REITs are today priced at even larger discounts. Here are just a few examples:

• Alexandria Real Estate Equities, Inc. ( ARE ): owns life science properties, its rents are growing, and it has an investment grade rated balance sheet, but it is priced at a 40% discount to its net asset value.

• AvalonBay Communities, Inc. ( AVB ) owns Class A apartment communities and it is similar to ARE in that its rents are growing rapidly and it has a strong balance sheet , but it is priced at a 30% discount to its net asset value.

• Vonovia SE ( VONOY / VNA) is perhaps the most extreme example. It is currently priced at a 70% discount to its latest net asset value. It is so heavily discounted because it owns properties mainly in Germany and the market is very fearful about Europe right now. But its rents are actually growing, it has an investment grade rated balance sheet , a great track record, and insiders are buying shares with their personal money.

So again, why would you buy private real estate today when you can get such deals in the public market?

Even private equity players like Blackstone Inc. ( BX ), Brookfield Asset Management Ltd. ( BAM ) and Starwood Property Trust, Inc. ( STWD ) have now turned their attention to REITs. Here is what billionaire Barry Sternlicht, CEO of Starwood, said on CNBC recently (emphasis added):

"By the way, when credit comes back, you are gonna see REITs take off. REITs are on sale. 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 because I do think that rates are going down." Barry Sternlicht, CEO of Starwood

Bottom line

I think that REITs are better investments than rental properties in most cases because they offer higher returns with less risk and hassle.

But there are exceptions. In late 2021, it made sense for me to buy a private property.

Today, however, REITs are a lot cheaper and offer better value for your money.

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