The old saying is that millionaires are made during a bull market, but billionaires are minted during a bear market.
And in that sense, the last couple of years have been a great time to be a real estate investment trust (REIT) investor.
It’s true that the real estate sector has underperformed in recent years. The Vanguard Real Estate Index Fund (VNQ) fell by as much as 38% between January 2022 and October 2023. That’s a bear market. No doubt about it. The table below should give you some idea of how tough it’s been for real estate.
Source: The Novel Investor
What you’re looking at is the various sectors of the S&P 500 Index and their performance in a given year. And what I’d draw your attention to is the Real Estate Sector in pink.
2020 was a tough year for real estate, down about 2% in the wake of lockdowns and the work-from-home trend. The asset class came roaring back in 2021, printing 46% returns. But then came 2022.
Real estate once again fell, producing -26% returns. And even though the market has rebounded slightly, it’s still way behind tech, communication services, and consumer discretionary, the top three sectors from last year.
But make no mistake: This difficult real estate market is an opportunity.
And I want readers to make the most of it.
Why Real Estate Fell
I spent much of my career as a real estate developer. So, I’m intimately familiar with the real estate cycle. You don’t want to get caught at the top as I did during the 2008 crisis.
However, buying premiere real estate assets at or near the bottom of that cycle can be a generational opportunity.
For instance, most people remember the real estate disaster that unfolded in 2008. But what few know is that the S&P 500 Real Estate Sector was the fourth-best of 2009, up 27%. And in 2010, this sector came out on top, printing a 32% return. It did it again in 2014, posting 30.2% returns that year.
It doesn’t happen often. But every once in a while, investors have the opportunity to buy these assets at temporarily discounted prices and reap the rewards.
That’s the opportunity I see now.
The recent REIT underperformance is based on fear and a poor understanding of the sector. You see, far too many investors think of REITs as an income-oriented investment and trade the sector as if it were a bond equivalent.
This short-term mindset means they’re often very interest-rate sensitive. But that thinking ignores compounding fundamentals…
Which is where our focus lies.
We fully acknowledge and embrace that REITs are “pass-through” businesses. They avoid income taxes themselves by paying at least 90% of their taxable income to shareholders… which means they can pay much larger dividend yields than your average income-producing asset.
However, that doesn’t mean they should be directly compared to bonds.
In recent years, the Federal Reserve’s hawkish policies have pushed the “risk-free” yields on bonds higher. And despite the U.S. government’s poor balance sheet, I have no doubt we’ll continue to provide interest payments on our debt.
Yet bond yields aren’t entirely “risk free.” There’s a major opportunity cost involved.
If you hold them to maturity, their yields are stagnant. They don’t compound organically. And therefore, the passive income they provide gets eroded away by inflation year after year.
REITs, on the other hand, have the potential to grow their fundamentals year after year, which should theoretically result in higher share prices. Admittedly, in practice, this doesn’t always happen since the market isn’t totally rational in the short term.
However, even if the market ignores reality and lets fear or greed dictate share prices in the present… blue-chip REIT executives tend to be more levelheaded than herds of traders on Wall Street.
And this results in a close correlation between rising profits and rising dividends.
Preparing for a Turnaround
REITs should have never gotten so low in the first place. But as we’re fond of saying, markets are a short-term voting machine and a long-term weighing machine.
Contrary to what you might believe, many of the best-managed REITs haven’t been struggling. On the contrary, there are plenty of REITs that are still growing their cash flows (and dividends) in this economic environment.
Put very simply, the businesses themselves have improved, but the stock prices remain well below their former highs.
Sometimes, markets make mistakes. But sooner or later, they always correct them. In this case, I’m betting on sooner.
Over the past few months, we’ve seen the sentiment surrounding REITs begin to shift in the markets. The VNQ is up by more than 10% since July. And many individual REITs have done much better.
Some of our favorite stocks from the sector are up double-digits from recent lows, and I think this trend is just getting started.
As I said at the top, the opportunity to buy premiere real estate assets at temporarily discounted prices does not happen often.
But every once in a while, it does happen.
Regards,
Brad Thomas
Editor, Wide Moat Daily
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Source: Wide Moat Research