Bull Case for REITs-and Home Buying

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Listen now. We're at the doorstep of a new real estate cycle, and that setup of low rates, the beginning of an economic cycle, demand and supply relationship for real estate in good shape, and quality balance sheets, it's attractive. And then again, as real estate's been in the crosshairs the pandemic or the bullseye of it, so to speak, if in fact the economy does begin to reopen this year, REITs should be a disproportionate beneficiary.

Welcome to the Barron Streetwise Podcast. I'm Jack Howe. The voice you just heard, that's Jeff Kolich. He's the manager of a top-performing real estate fund called Barron Real Estate, and he thinks now is an excellent time to buy real estate investment trusts, or REITs. We'll hear his case in a moment, and we'll get his top REIT picks and those of a Wall Street analyst. And we'll gather some thoughts along the way about buying or selling a house this year. I feel like this episode is a cozy fixer-upper with real potential. What do you think, Meta?

Yep, I think there's real floors under those carpets.

Oh, do not look under the carpets. That's a mistake. Listening in is our audio producer Meta. So Meta, You know that I just bought a house. I do, yeah. Congratulations. Thank you. My family and I are excited to move. We're moving from the center of our town where all the houses are fairly close together to the outskirts of town where the houses are spread apart. It's quite woodsy. I've always wanted to be a forest ranger and my rough plan is to just walk through the woods and, you know, keep an eye on things. Maybe buy an imposing hat, issue a stern warning if I see any squirrels fighting. What do you think, Meta?

I don't know, New York suburbs have some pretty tough squirrels.

Mm, you're right. I better watch my six, as they say in the cop movies. Stay frosty out there.

Yeah, and maybe get a rabies shot.

Thank you, Meta. For listeners who are thinking of buying or selling a home this year, I have 2 data points and 1 anecdote. The first data point is that US house prices rose 10.4% last year. That's the fastest increase in 7 years. It's according to something called the S&P CoreLogic Case-Shiller Index. And that's reported with a bit of a lag. December numbers just came out this week. They show that the rate of price appreciation accelerated in December from November. It's been picking up since last summer. The second data point is the 30-year mortgage rate, which bottomed out in early January at around 2.6% and since then has risen to close to 3%. That's according to Freddie Mac. You might find different rates at your bank, but whatever they are, I'll bet they're up over the past several weeks. And that loosely tracks what's happening in the bond market. The 10-year Treasury recently yielded close to 1.5%. That's exceptionally low historically, but it's up from less than 1% at the beginning of the year. So why are bond yields rising and bringing mortgage rates with them? One reason is that the outlook for the economy is brightening. We talked last week about the huge upside surprise in company earnings for the fourth quarter of last year and the expectations for strong earnings growth this year. Jonathan Golub, the chief stock strategist at Credit Suisse, wrote this past week that the U.S. economy this year could run the hottest in 35 years. Growth like that gets investors thinking that prices could soon rise quickly, not just for stocks and houses, but for ordinary consumer goods. That's inflation, and if it gets too high, the Fed might have to respond by raising interest rates sooner than expected. And since investors are forward-looking, bond yields have been rising in anticipation of higher inflation. Look at what happened this past Tuesday. Stocks tanked in the morning. Then Fed Chairman Jay Powell spoke to the Senate about the state of monetary policy, something he does twice a year.

He said, continued progress in many industries has been tempered by significant losses in industries such as leisure and hospitality. He also said millions of Americans remain out of work, and he said for some of the sectors that have been most adversely affected by the pandemic, prices remain particularly soft.

I know that sounds like a bad report, but the stock market roared back. Investors took all the gloominess to mean that the Fed isn't going to try to move interest rates higher anytime soon. Then the stock market continued swinging back and forth like that throughout the week. All right, back to houses. Whether mortgage rates continue to move higher will depend upon whether the Fed is right that inflation looks contained. If so, rates can stay low. If inflation jumps, so might mortgage rates, and high enough mortgage rates might make potential home shoppers less eager to buy. If that happens, growth in prices could stall or even reverse. I said I had one anecdote, and that's simply that when I listed my house in the middle of town, it sold almost immediately. There were multiple offers above the asking price. But the house we bought out in the woods, that one's a little more expensive. It had been on the market for a while. The broker said he's been seeing a lot of that in our area— fierce demand for mid-price houses and only ordinary demand for higher-priced houses. To me, that suggests that conditions aren't easy for first-time home buyers who are looking for mid-priced homes. But then real estate is very local, so prices aren't high in all areas. Mortgage rates remain exceptionally low, so buyers who can find houses with somewhat reasonable prices might still be getting good deals if they plan to use a lot of financing and pay it off slowly. And whether or not they're looking for an inflation hedge, they'll get one. Inflation can gradually drive up the price of housing and eat away at the value of housing debt. That's also the view of Ron Apta, who has his own realty company in San Francisco called Polaris Realty. Hey, Ron, how you doing?

Hey, Jack, how are you?

Ron says condos in his area have done okay, but the higher-priced ones have been weakest. And he says single-family homes have continued to do well during the pandemic because As he puts it, you don't have to share an elevator and you have your own backyard. Now I know what you're thinking. Ron's a realtor and realtors always think it's a good time to buy. Well, I've got news for you. Ron thinks it's a pretty good time to buy.

I'm going to say yes, not because obviously I'm in it for the commission check, but truly because I've seen that as long as you can hold on to the property for a long enough time, 5 to 7 years, let's say, you can ride out any bump. And I think the big push why I think right now is a great time is that San Francisco has been hit You know, it's very few times that San Francisco's on sale that I've seen in my 50 years of life. And when it happens, you need to pounce.

Ron will have some tips for home sellers later in this episode. And by the way, I feel like I'm getting a good deal on my move to the woods, but I don't want to give the impression that my home purchase had anything to do with market timing or portfolio strategy. We simply wanted more space. The new house will cost a bit more in ways that are mathematically indefensible. I'll spend more on heat, but I won't be any warmer. I'll pay more in property taxes, but I won't send any more kids to school. I'm spending the money because I think it'll bring my family joy over the next couple of decades. Nothing about it feels really squanderous. Except maybe the part about the forest ranger hat. I'm going top of the line on that baby. Before we come back to home buying, let's talk about investment property. We've had a couple of questions from listeners about REITs, real estate investment trusts. Those trade like stocks and they own property—stores, hospitals, office buildings, apartment buildings. They don't have to pay corporate tax on their profits so long as they pass the bulk of it on to shareholders as dividends. Investors tend to think of REITs as income investments, and many are, with dividend yields that are well higher than the stock market average. But there are also REITs that focus more on growth. Okay, one listener asked if I had changed my mind about REITs. In an episode of this podcast last summer, I said I don't think REITs are a necessary add-on for investors with otherwise diversified portfolios. I don't think most things are necessary beyond stocks and bonds. If you have an index fund that tracks the S&P 500, for example, you already have some real estate exposure in the form of all the property those companies own, plus there are REITs in the index, and you might own a home yourself. But that doesn't mean I think REITs are a bad idea for investors who like them, and many do, so I cover them from time to time. REITs were a noticeable underperformer last year, and I wanted to find out whether that makes them a good deal now. A few weeks ago, I spoke with Brent Dilts, a REIT analyst at UBS, the big investment bank. He said REITs look attractive now, but he definitely prefers some types over others. His favorite group is industrial REITs that own warehouses. Now, warehouses might not sound exciting, but they're the key to e-commerce, which has boomed during the pandemic. And which Brent expects to continue to thrive, creating strong demand for more warehouse space. He also says that supply chains have gotten too tight. Think about how toilet paper ran out last spring, causing people to hoard. It's not that companies couldn't make enough toilet paper, it's that retailers had taken a just-in-time approach to having goods delivered. Now, many want to build more of a cushion in their inventories. That takes more warehouse space.

So now there's this view that we need to build the supply chain here in the US by 5% to 10%. And if you do that, that is a material amount of logistics and warehouse space that'll be required. And on top of that, because the supply chain has been so, you know, it was so tight heading into COVID, we're at all-time lows or near all-time lows from a sales-to-inventory or an inventory-to-sales perspective. So not only do we have to build, but we have to catch up to where we were pre-COVID. So it's a pretty significant tailwind.

Brent's top picks among warehouse REITs are Prologis, ticker PLD, and Duke Realty, ticker DRE. Prologis operates worldwide and yields 2.2%. It's managed more for growth than income. Shares of Prologis have lagged well behind the S&P 500 over the past year, But if you've owned them over the past 3 years, you've made a total return of 82%, including price gains and dividends, which means you've outperformed the S&P 500 by more than 30 percentage points. Again, that's Prologis, which operates worldwide. Brent's other warehouse favorite, Duke Realty, is focused more on the U.S. It yields a touch more, 2.5%, and it's outperformed by less. About 20 points over the past 3 years. Brent's least favorite group at the moment is office REITs. He says some of them are still down a lot, but that doesn't mean they're trading at big discounts to what they're worth. We know that the pandemic will eventually ease and offices will reopen. Not everyone who's working from home now will go back, but then again, companies might want more space per worker for those who do go back to the office. Those are offsetting factors. Brent says that when you net them out, he expects a 10% to 15% decline in demand for office space in the coming years. We're talking urban, not suburban. He points out that even before the pandemic, the demand trend in office space was negative, with the exception of the technology sector. He says companies are still trying to figure out how much office space they'll need.

Now that COVID's hit, it's really led to this upended model where all these large corporates are trying to figure out, all right, do we need this much space? How much money can we save? But they're balancing that against how do we maintain our culture and how do we train younger people, right? You can't hire someone out of college and just set them loose in their living room. That hasn't historically worked well. So there's a lot of things to balance with that. But then when you look at some more seasoned, like mid and later stage employees who know what they're doing and maybe prefer the work-life balance, They don't want to commute anymore in some cases. You know, there's a real mix.

One key question for office REITs has to do with flex schedules and who gets a desk.

If you do 2 or 3 days, the real debate becomes, do you have a dedicated office of your own anymore? Or do you kind of like have a hot desk relationship where you don't have a set desk and there's nothing personal on it and you just come in for your 2 days and then someone else uses it for the other 2 or 3 days that week? That's kind of where the debate is headed and there's not much clarity around it. A lot of the offices have not been reconfigured yet. To really give any insight into that.

Okay, so Brent's an analyst, which means he covers certain REITs. And to learn more about where to find value in REITs, I wanted to talk with a money manager who selects among all of them. Hi, Jeff.

Hi, Jack, how are you?

I'm doing well, thanks. I see you— I want you to know that I'm the kind of high roller that invests in anti-reflective glasses, but I broke them, so I'm using $7 readers from the CVS. So the glare from my glasses I just want you to know that I'm better than that. I've got a new pair on the way. They'll be here tomorrow.

Listen, I don't judge a book by its cover, so to speak, so I'm not worried about the glare. All good.

That's Jeff Koelich. He manages the Baron Real Estate Fund, ticker BREFX. That's Baron with one N, no relation to Barron's with two N's that I work for. Jeff seems to be pretty darn good at his job. Morningstar ranks his fund in the top 1% of real estate funds for the past 1, 3, 5, and 10 years. The dividend yield is low, under 2%. Jeff manages that fund more for growth than income. Over the past 5 years, investors have made an average total return of over 22% a year. Jeff also manages a newer fund for investors who want more yield. That one's called Baron Real Estate Income. Ticker BRIFX. The yield is closer to 3%. The fund ranks in the top 5% over the past 1 and 3 years, and the average return over the past 3 years is just over 19% a year. Jeff is broadly bullish on REITs, as you might imagine. He says now's a particularly good time to buy. I asked him to explain why.

Much of real estate lagged last year because it was in the bullseye of the pandemic. The business models are based on the assembly of people, and so clearly if you you can't bring people together, whether it's office buildings, apartments, hotels, shopping centers, malls, these businesses are going to suffer. That in turn led to many of them are on sale. And when we look at REITs right now and many other non-REIT real estate related companies relative to equity alternatives, bond alternatives, the private market, real estate's attractively valued. Then you layer on most real estate cycles tend to last 5, 6, 7 years. We're at the doorstep of a new real estate cycle and that setup of low rates, the beginning of an economic cycle, demand and supply relationship for real estate in good shape, and quality balance sheets, it's attractive.

Jeff says REITs in general tend to trade at a premium to the rest of the stock market relative to cash flows because cash flows for REITs are predictable. But he points out that REITs now trade at a discount to the market. Like Brent at UBS, Jeff likes industrial REITs with warehouses. Unlike Brent, he thinks some office REITs trade cheaply enough to make the risk worth taking. He gave an example of how he thinks the market has overshot to the downside. An office REIT called Douglas Emmett, ticker DEI, had recently reported weak financial results, but its shares didn't really respond to the bad news.

The stock's flat with very challenged results, which is telling us that challenged results isn't news. It's already in the stock. Then you get to value, and its office assets are trading at an implied value of around $475 per square foot, while just recently in the last year or two, assets in their markets on the West Coast were trading for over $1,000 a foot. So it's effectively trading for 40, 50 cents on the dollar.

Jeff also mentioned an office REIT closer to his home called Vornado, ticker VNO.

Yes, New York office REITs landlords will remain pressured. But when we look at a Vornado, for example, and we're looking at where it's trading right now, when it's yielding about a 5.5% dividend yield, again, we believe that the concerns are largely discounted. The stock was down 40-some-odd percent last year. They have a strong balance sheet. So again, bad news isn't new news when you have stocks that are down so much, yielding high, and they have a strong balance sheet.

What about those high dividend yields? Not just for office REITs, but across the sector. Are REIT dividends broadly at risk of cuts in the year ahead? Jeff says just the opposite is the case.

We're not overly concerned about dividend cuts at this stage. Most of the companies have addressed the dividend issue in 2020. In fact, we think dividends are going to become a tailwind over the next couple years as many of these companies, if in fact the economy does begin to reopen and cash flow begins to improve, we're going to see the direction traditionally dividends improve and increase from here. I would also say that many of the REIT companies that we have focused on have done just a tremendous job over the last year focusing on their balance sheet, preserving capital, extending debt maturities, making sure that they have an appropriate level of debt relative to the cash flow needs and an ability to pay their dividends.

What about if interest rates continue to rise? That's usually bad for bond returns and REITs aren't bonds, but they're income investments, and that can make them sensitive to changes in interest rates. Jeff says he's not especially worried so long as rates rise only gradually, because that tends to reflect an economy that's improving. If rates soar, he says, that could cut into the relative appeal of REITs. I asked Jeff to share some of his top picks. He mentioned one earlier, Douglas Emmett. He also likes Equity Residential, ticker EQR, and Sun Communities, that's SUI. Those are housing REITs. He mentioned a cold storage REIT called Americold, ticker COLD, and he likes the single-family rental market including American Homes 4 Rent, ticker AMH, and Invitation Homes, INVH. Now, Jeff's a real estate investor, not a realtor, but I asked him, you think it's a good time to buy a house? He does.

We're quite optimistic about the prospects for residential real estate. There is a powerful combination of cyclical tailwinds and secular tailwinds right now. The headline for someone that's buying a home is the following: one, from a cyclical perspective, there is still a housing deficit in this country. So we have a shortage of supply relative to the demand needs. Which in turn, if you or someone is considering buying a home, directionally we think home values are going to be headed higher in the years ahead. When you overlay the ability right now to purchase a home literally at the lowest mortgage rates ever on record, the headline is it's a very attractive time to buy a home.

Meta, you hear that? Jeff says I'm riding powerful cyclical and secular tailwinds.

Do you need to see a doctor about that?

And finally, as promised, Ron the Realtor from San Francisco has some tips for anyone looking to sell a home this year.

You can't discount emotion. And if somebody's got an emotional attraction to a property because of the curb appeal, you say if you can change how the property looks even before you go inside of it, maybe painting the facade, doing something, some flowers, anything to kind of increase what I call a first impression item. So even before you walk in the door, you might subconsciously be attracted to the property and not realize it. Like when you find your significant other, there might've been something subconsciously you didn't realize you were attracted to that person, makes you want to get married to them. Same idea with a house. Like you really want to make sure you fall in love with it. And how do you do it? You make it look very attractive. Externally.

Okay, so paint the facade and put in flowers. Here's a tip for inside the house. It's about the old saying that kitchens and bathrooms sell houses.

That old phrase is 100% accurate. So cleaning up, touching up the kitchen and the bathrooms to the extent you can— if that means painting the cabinets, changing the pulls, swapping out appliances, changing light fixtures, things to just give it a more modern aesthetic or a little more contemporary, or just modernize it as best you can. And those are the things that I think help out the most.

Thank you for listening. On behalf of our producer, Meta Lutzov, I'm Ranger Jack saying— what do you think this rash is here? Is that poison ivy? I'm gonna put some calamine on that, I think. Subscribe to the podcast. Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. And if you listen on Apple, please write us a review. If you want to find out about new stories and new podcast episodes, you can follow me on Twitter. That's @jackhowe, H-O-U-G-H. See you next week. Model portfolios are no longer one size fits all. In fact, 85% of investors want financial advisors to deliver models customized to their individual goals investment preferences, and tax circumstances. Discover some of the top themes driving the shift in Seizing the Next Model Moment by BlackRock.