Investment Strategy

The REIT approach to real estate investment

As investments go, real estate is pretty easy to understand. But directly owned and managed properties can be a lot of hassle. Fortunately, there’s another way to invest in real estate that, done correctly, offers highly attractive profits and some other major advantages. This alternative is to buy shares of “real estate investment trusts”, or “REITs”.

REITs are very simple businesses. They own some buildings or land, usually partly funded with debt. The company collects rental income and maintains the real estate. Fees are paid to a management company. The net profit is paid to investors as dividends.

In the US, for a company to qualify as a REIT it must make 75% or more of its income from real estate and pay 90% or more of its profit to shareholders as dividends. If it fits the bill then it doesn’t have to pay corporate income tax. Investors, however, may still have to pay income tax on the dividends they receive.

A typical REIT might have a balance sheet that looks something like this:

A large part of the funding usually comes from long term debt, meaning the assets are leveraged. This is just the same as any homeowner who uses a mortgage to fund part of their house purchase.

There are lots of different types of REITs. Sub-sectors include retail (shops), residential (homes), office, health care (e.g. hospitals), industrial (e.g. warehouses), hotel & resort, diversified (a mix) and specialised (everything else). Specialised REITs own things like movie theatres / cinemas, timber farms, race tracks, sports stadiums, golf courses and self-storage facilities.

There are also mortgage REITs which invest in mortgage-backed securities (MBS), which are just bonds based on mortgage loans. These REITs often contain complex financial derivatives to hedge market risks. Essentially, mortgage REITs are intransparent hedge funds and best avoided.

The MSCI US REIT index has 155 REIT stocks in it. It also excludes mortgage REITs, meaning it only includes REITs that own physical property (which is good). This is how it breaks down by sub-sector.

You can see it’s well diversified. This illustrates an important advantage of REIT investing over directly owned property. It’s easy to spread your bets.

You could buy a single $300,000 house in a nearby town, financed with a mortgage of $200,000 and $100,000 of your own money. Or you could put that $100,000 into, say, five different REIT stocks spread across many different sectors and geographies.

Now let’s look at investor profits.

Historically, the MSCI US REIT index made an average, pre-tax, compound return of 10.62% a year between 30th December 1994 and 31st August 2017. That compares with 9.91% a year for the MSCI USA IMI of stocks in general (“IMI” means investable market index).

In other words, over the long run and before tax, US REITs have beaten the broader US stock market. Sounds great.

That said, things haven’t been so favourable over the past decade. The 10 year performance of the MSCI US REIT index is 6.25% a year, versus 7.85% a year for the MSCI USA IMI. That’s perhaps not surprising given the big real estate bust a decade ago, and the current bubble in other, non-REIT sectors of the US stock market (see here for more).

REIT investor profits come from three sources:

  1. Dividend income (and sometimes stock buybacks)
  2. Increases in the value of the company, driven by rising property prices over time
  3. Increases in the valuation multiple placed on the stock

Cash income within the REITs comes from rental income. Set against that are the cash outflows: operating costs, interest expenses, management fees and capital expenditure to maintain the buildings.

Also, as property prices rise, the REIT can increase its borrowing from time to time. The idea being that the ratio of debt to property values stays more or less the same. It’s similar to a homeowner taking out an additional mortgage on their home to release some funds. By maintaining leverage in this way, the REIT structure has an additional and ongoing source of cash.

Putting these pieces together you get the net cash flow available for distribution to shareholders. That comes mainly as dividends but with some used for stock buybacks (especially in the USA).

In the case of the MSCI US REIT index, the dividend yield currently stands at 4%. The buyback yield isn’t disclosed, which is a common problem and complication with stock indices, especially in the US where buybacks are so widespread. Perhaps the true yield on the index is closer to 5%, including buybacks, but it would take a lot of analysis to confirm.

How do you value a REIT?

What about valuation? A REIT is just a vehicle that owns an asset that itself trades in an active market (the real estate market). A REIT stock is merely a part share in that vehicle.

 

What this means is that a REIT should be worth the market value of its properties, plus other assets, less debts and other liabilities. That’s the same as its net asset value, also known as book value or shareholders’ equity (see the balance sheet diagram above).

Put another way, the price-to-book ratio (P/B) should always be equal to one, or at least very close to it. If it’s above that level, at say 1.2, the investors are overpaying for something that could be replicated more cheaply. If it’s below that level, with P/B at say 0.8, then the REIT could be liquidated for an instant profit.

A complication with REITs in the US

Looking at the MSCI US REIT index, the P/B ratio is 2.3, which at face value makes it look massively overvalued. So what’s going on?

The problem is that, at least under US accounting rules, the properties that REITs own aren’t held on the balance sheet at market value. Instead they’re reported at what was paid to buy them (historical cost) less depreciation over time. In other words, US REIT assets are usually massively undervalued in the accounts – especially after many years. This depresses the book value and inflates the P/B ratio.

Most other countries do the sensible thing and allow REITs to value their properties at current market value. This is usually done with the help of outside real estate consultants. The result is that P/B ratios rarely stray too far from 1.

To illustrate this, there’s a REIT ETF that trades in Singapore called the Philip SGX APAC Div Leader REIT ETF (SGX:BYI). It invests in REITs from places like Australia, Hong Kong and Singapore.

BYI currently has a P/B ratio of 1.02, which is pretty much bang on where it should be. That’s assuming all the real estate assets are being reported on the REIT balance sheets at their true market values.

Meanwhile, back in the US, investors have a harder time. They need to find experts who can estimate the true values of assets owned by individual REITs. Based on that they can arrive at a meaningful P/B ratio as the basis for deciding if the REITs are cheap or expensive.

There’s an ETF that tracks the MSCI US REIT index called the Vanguard REIT ETF (NYSE:VNQ). It’s got $35 billion of assets, which is a lot of investor money.

But, given US accounting standards and the way it messes up valuation ratios, I have no way of knowing if the ETF is good value or not. (It’s probably okay, with a 4-5% yield. Although unlikely to be in cheap territory.)

Improving the profits

Real estate values tend to more or less follow inflation in the long run, perhaps beating it by a small margin. That said, obviously there are short periods where prices rise much faster (or, for that matter, fall).

Quicker price rises happen either because they start at rock bottom after a crash (USA in 2011, Hong Kong or Argentina in 2002, Britain in 1995 etc.), or because they launch into bubble territory for a while (multiple locations in 2017 – see here for some examples).

However, in the long run, a reasonable expectation for property price gains should be inflation plus 0-2%. At the same time the yield on REITs – both from figures above and my past experience – should typically fall in the 4% to 6% range.

Put those together, and take the mid-points, and investors can expect something like a 6% real (above-inflation) return, before taxes. Or, if inflation is 2%, 8% overall. That’s highly attractive in a low yield world.

But REIT investors can do much better than that if they’re selective. That’s because stock markets have a habit of delivering fantastic bargains from time to time.

For best results, investors should buy REITs when the P/B ratio is well below 1, using market prices for the real estate assets (remember: this needs adjustment in the US). Fortunately, stock markets are extremely inefficient and these opportunities occur regularly.

For example, back in August 2010 I spotted a REIT in Singapore that owned top quality office and retail space, all of it right in the middle of the central business district of that financial centre. It was trading with a P/B ratio of just 0.79, meaning nearly 27% upside to fair value of 1. Put another way, there was a huge “margin of safety”.

Over the next (roughly) four years the discount narrowed until it reached a P/B of 1. The total profit was 68%, working out at 13.5% a year before tax. That’s a great result in what I consider to be a low risk investment.

Breaking that out, I estimate it was 3.7% a year from increases in the underlying book value, 1% a year from currency gains, 4.9% a year from dividends and 3.9% a year from the increased valuation as the discount (rightly) disappeared.

REITs have a number of important advantages over directly owned real estate. That’s provided you have the patience to ignore short term stock price swings, which usually don’t reflect what’s happening in the real world.

These are the main advantages of REITs:

  1. Minimum hassle: no tenants, management companies, mortgages to deal with
  2. Professionally managed for you (if selected carefully)
  3. Income can be reinvested immediately in more REIT stocks for maximum compounding
  4. Income is stable and usually high.
  5. It’s easy to diversify by sub-sector and geography
  6. You can invest relatively small amounts
  7. REITs, like most stocks, are liquid and easy to buy or sell quickly

If you’re keen to invest in real estate, but don’t want the hassle of owning it directly or don’t have enough capital for a large single investment, REITs can be a highly attractive way to go about it.

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com


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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.

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