GNL - Why I Won't Buy REIT ETFs

2023-05-25 08:05:00 ET

Summary

• REITs are offering a great opportunity right now.
• You could buy REIT ETFs or individual REITs.
• I explain why I won't invest in REIT ETFs and present an example of an individual REIT that will likely deliver higher returns.

I believe that real estate investment trusts, or REITs, are the best opportunity for 2023.

They essentially allow you to buy income-producing real estate at 50 cents on the dollar, and you then get the added benefits of liquidity, professional management, and diversification on top of that for free.

Their share prices crashed in 2022 even as their cash flows kept on rising, and as a result, their valuations are now comparable to those of 2008:

The opportunity is so big that it has even gained the attention of the big private equity players like Blackstone Inc. (BX) and Starwood (STWD), who are now loading up on REITs. Blackstone alone bought about $30 billion worth of REITs since the beginning of 2022. Here is what Blackstone and Starwood have recently said about REITs:

"The best opportunities today are clearly in the public markets on the screen and that's where we're spending a lot of time." Jonathan Gray, President/COO, Blackstone Q2 2022 Earnings Call .

"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.

So REITs are very opportunistic right now.

But how can you invest in them?

You really have two main options:

Option 1: You could invest in a REIT ETF like the Vanguard Real Estate Index Fund ETF Shares ( VNQ ) and be done with it.

Option 2: You could invest in individual REITs and build your own portfolio.

Both options have pros and cons. Option 1 has the advantage of giving you diversified exposure to the REIT sector at minimal cost and it won't require much effort from you. It is a passive strategy.

But ultimately, I went with option 2 and have been actively investing in REITs for about a decade.

Here are 5 reasons why I won't invest in a REIT ETF:

Reason #1: Alpha Is Real And Attainable In The REIT Sector

The market is incredibly efficient these days. As a result, it has become very difficult to outperform the market.

This is especially true for large-cap stocks such as those of the S&P 500 (SP500). There are so countless analysts and investors looking for opportunities, and it makes it nearly impossible to earn alpha.

But the REIT sector is an exception.

It is one of the few sectors in which active management has been able to add value in the past, and studies show that alpha is real and attainable for more sophisticated REIT investors.

I believe that this is because REITs are a bit of a weird category for investors. Real estate investors don't trust the stock market, and stock market investors don't understand real estate. Being a hybrid of both has put REITs in an odd category with few knowledgeable investors and relatively many market inefficiencies - causing REITs to often trade at large discounts/premiums to their NAVs.

I believe that I have an advantage over most market participants because I come from a private equity real estate background, combine that with the CFA education (passed all three exams, but never applied for the title), and have somewhat better access to management teams thanks to my following on Seeking Alpha.

Historically, this has allowed me to cherry-pick the best REIT investment opportunities and it has led to significant market outperformance. Sticking to an ETF would be easier, but it would also leave money on the table.

Reason #2: ETFs Invest Mostly In Very Big REITs

Most ETFs are market-cap weighted, and a consequence of that is that they will invest most of their capital into the largest and best-known REITs.

The issue here is that these are the most scrutinized companies and that are the least likely to be undervalued. In fact, they are today a lot more expensive than the smaller and lesser-known REITs. The reality is that most institutional investors manage so much capital that they simply can't invest in the smaller REITs because of liquidity issues - and it has led to a lot lower valuations.

Here is a great table from Simon Bowler's recent article :

It shows you that the smaller REITs are heavily mispriced, but the larger REITs are trading much closer to fair value on average.

ETFs don't give you enough exposure to the smaller REITs.

Yet, that's what I want.

Reason 3: ETFs Invest Across All Property Sectors

The REIT market is vast and versatile.

Today, REITs invest across 20+ different property sectors and some are a lot stronger than others.

To give you an example: Some industrial REITs like EastGroup Properties, Inc. ( EGP ) are today still able to push for 20%+ rent hikes as leases expire because there is so much demand for urban warehouses in sunbelt markets.

But at the same time, some office REITs are experiencing rapidly declining occupancy rates as increasingly many companies decide to lease less office space. This is just to say that it is very important to be selective when investing in real estate. Here's how some of the biggest office REITs ( BXP ; SLG ; VNO ) have performed over the past year:

You would rather avoid that.

But ETFs like the Vanguard Real Estate ETF still invest in these REITs. They are not in the business of picking and choosing the right property sectors at the right time. Instead, they will allocate capital across all REITs, whether they own good assets or not.

Today, these ETFs will typically include offices, malls, hotels, mortgages, and other sectors that could prove to be problematic in the long run. Zoom ( ZM ) is replacing offices... Amazon ( AMZN ) is replacing malls... Airbnb ( ABNB ) is hurting hotels... And mortgage REITs are simply overleveraged in many cases.

Reason #4: ETFs Invest In Good, Average, And Bad Apples

The most important factor in predicting the long-term performance of REITs is their management quality.

A REIT may own the best assets and have a strong balance sheet, but it will still underperform in the long run if its management is conflicted.

On the contrary, a REIT with just average properties may outperform if its management is shareholder-friendly and has the right plan in place to maximize value.

So, management quality is extremely important.

But again, ETFs are not in the business of picking and choosing. They invest across the board and so they will include poorly managed REITs as part of their portfolio.

Just to give you an example: you could outperform the REIT sector averages by simply skipping externally-managed REITs because the external management structure leads to greater conflicts of interest and these REITs have underperformed in the long run. Some examples include Office Properties Income Trust ( OPI ) and Global Net Lease ( GNL ).

It is very easy to identify and avoid those, but ETFs will still invest in them.

Reason #5: ETFs Don't Offer Enough Income

The biggest REIT ETF today yields about 4%.

That's simply not enough for a real estate investment, in my opinion.

I aim to earn closer to double that.

Real estate should be an income investment first and foremost, and I want to earn income while I wait for long-term appreciation.

This helps me to stay patient and it also makes me less dependent on market appreciation to earn attractive total returns.

The "Landlord" REIT Investing Strategy

I named my newsletter "High Yield Landlord" because I invest in REITs just like how a landlord would invest in rental properties: I try to get a good deal to earn a higher yield and enjoy greater long-term appreciation.

On average, I end up investing in just about 1 REIT out of 10:

My selection process follows some simple rules:

• Favor smaller and lesser-known REITs that give more value for your money and avoid large-cap REITs that are overpriced.
• Focus on stronger property sectors to avoid value traps.
• Avoid REITs that are poorly managed.
• Try to get shares at a steep discount to their net asset value.
• Target a 6-8% dividend yield to earn significant income.

Example Of A REIT To Buy Today

An example of an attractive pick today would be BSR REIT ( BSRTF / HOM.U).

This is a small-cap apartment REIT that specializes in rapidly growing Texan markets like Austin, Dallas, and Houston.

These markets are today experiencing rapid growth as increasingly many companies decide to move from coastal markets like California to Texas.

As a result, rents are growing at a good pace, but despite that, the company is priced at a steep 40% discount to its net asset value and just 13.6x funds from operations ("FFO") - an exceptionally low valuation for a REIT of this quality.

The yield is relatively low at 4%, but this is because the REIT retains nearly 50% of its cash flow, which it then uses to buy back stock.

It is by targeting such situations that we aim to outperform at High Yield Landlord.

Our Portfolio currently has a 6% average dividend yield with a low 56% payout ratio, and it is priced at just 9.4x FFO on average, providing margin of safety and superior upside potential:

For further details see: