Real estate investments take a variety of different forms. They can be tangible assets bought and managed by yourself or by a 3rd party, such as a property management company. They can also be a more passive security such as a publicly traded real estate investment trust, which has many similar characteristics to a stock investment, including liquidity, market price volatility, etc. Beyond these different forms of real estate, there are various types of real estate such as residential, industrial, office, experiential, self-storage etc. In financial markets over the last several years since the Federal Reserve has been aggressively raising interest rates, there has been a major divergence between the performance of these types of real estate, particularly residential home prices, and commercial-type assets. Commercial real estate prices have dropped by varying degrees based on the type, but many publicly traded REITs are still down 25-50% from their highs, but this has not been the case for residential housing, despite similar interest rate headwinds. To be clear, I’m not saying housing prices are going to plummet whatsoever, I’m just pointing out the difference between commercial and residential valuations and highlighting why we think the opportunity in commercial is so compelling.
There was a great article in the WSJ about residential real estate, which I summarized and quoted from below:
Housing prices are now up about 50% from the end of 2019, but owner-equivalent rent, which is the stream of income that could be generated from the home if you chose to rent, is up only 24%. According to many metrics, homes are as overvalued as they were during peak Housing Bubble years in the mid-2000s. For instance, according to the National Association of Realtors, the increase in the monthly payment on a newly purchased and financed home, is up 114%, which speaks to how challenging the major increase in interest rates is on new home buyers, coinciding with that increase in prices. Higher interest rates can also pressure real estate asset valuations, because investors have alternative income-generating investment options that might offer better returns with less risk than a rental home bought at current levels.
“A model in the Fed’s semiannual financial stability report incorporates all these elements and shows that homes are now 25% overvalued, just below the 28% peak in 2007, using the Labor Department’s measure of rent, and 19% overvalued using private measures of market rents.”
“In the short-run, supply and demand easily swamp valuation. Burns Research estimates underlying U.S. demand for homes exceeds supply by 2.1MM units, whereas in 2009, supply exceeded demand by 1.9 million. Founder Joun Burns said it usually takes a recession or financial crisis to push prices down, so if that isn’t your forecast, you should expect prices to stay high.”
There are many reasons to buy a home, far beyond the scope of investing, but the reality is that for many people, their home is their biggest investment, so it does at least make sense to understand the field that you are playing on. While higher prices and higher rates might make buying a new home challenging for most, opportunities can emerge when gluts of specific properties hit the market all at once in various regions. In such conditions, one might discover a relative bargain. People often need to relocate for employment, begin families, or face the unfortunate event of divorce. Additionally, the hassles of renting can become burdensome, making home ownership a highly recommended option when it is financially and practically attractive for you. Another factor to consider is that selling your home could capture a significant increase in its value, making the purchase of a new home more attainable with that advantage. However, unless you can pay in cash, the mortgage expenses for the new home are likely to be substantially higher, which explains the low turnover rate for existing homes.
In the commercial sector, bargain hunting currently presents a more attractive opportunity, as we’ve consistently emphasized. We’re acquiring shares in some of the top-tier, diversified, and financially robust commercial real estate firms, which offer dividend yields ranging from 5.5-8%. These dividends are expected to compound significantly in the coming decade. To be clear, we’re not focusing on the office space sector, which faces greater challenges at present. While a stable 6.5% growing dividend may not seem thrilling in a market that appears to overvalue AI stocks, investors aiming to optimize their retirement should find this very appealing. These commercial real estate investments hold substantial growth potential beyond their dividends. As rents rise, earnings will increase, and I anticipate a rebound in valuation multiples from their current depressed levels. These stocks could potentially deliver mid-teen annual growth rates over the next 5-10 years, an excellent outcome that, in my view, surpasses likely equity market returns, hence our aggressive purchasing strategy. Additionally, we employ strategies like covered calls to often achieve a combined dividend and annual call premium in the double digits, while still maintaining significant stock upside.
We have also been buying the bonds on a lot of these companies which offer yields between 6-9.5%, despite what we believe to be a very attractive risk/reward profile. Just like with residential housing, these companies and bonds would benefit from rates declining. Commercial real estate indeed seems priced for a recession, while residential is not, so that is just something to consider. As always, I want to reiterate that these articles are my opinions and thoughts. They are never meant to alienate anyone that disagrees with those opinions, as debate and the sharing of free thoughts is what makes this whole investing thing so fun! I’ve been wrong many times and I will continue to be at times in the future, but it will never be from a lack of effort, I can assure you of that!