In a recent interview, billionaire investor Howard Marks explains that real estate, retail, entertainment, and hospitality stocks are the best opportunities right now. He then adds that:
“We have developed a real dichotomy between the things that are obviously successful but expensive, and the things that look low priced but are challenged in terms of business. And big money will be made by buying the latter which works.”
He puts a clear emphasis on buying “out-of-favor” businesses “that will still work” in the future. In other words, companies that are undervalued because of temporary pain that will be forgotten in the recovery.
What would be a good example of something “hated that will still work?”
We believe that apartment REITs are precisely that. Most of them are hated and offered at a >30% discount relative to pre-crisis valuations. Yet, their long-term prospects remain very attractive, and now is a great time to buy them while they are still discounted:
- Camden Property (CPT): down 24%
- AvalonBay Communities (AVB): down 32%
- UDR Inc (UDR): down 34%:
- Essex Property (ESS): down 39%
- Equity Residential (EQR): down 40%
- Clipper Realty (CLPR): down 45%
Apartment REITs: The Opportunity of 2020
Historically, it always has been a good idea to buy apartment REITs when they were priced at low valuations during times of crisis.
We always will need shelter, and apartment REITs always have bounced back and outperformed most other market sectors in the long run:
Today, apartment REITs are again discounted. This time, the sentiment turned negative because some rents have gone missing, occupancy rates are slightly lower, and there’s also the fear of an urban exodus.
While it leads to some pain today, we believe it’s mostly irrelevant to the long-term prospects of these companies. And as our retired author, R. Paul Drake, recently noted:
“No amount of temporarily lost income can justify the substantial price decreases of apartment, net lease, and retail REITs in the market this year.”
To understand this point, you have to consider that apartment REITs should be valued based on their expected cash flow over many decades. Therefore, the impact of slightly lower rents in a single year should be minimal in an efficient marketplace.
The only thing that could justify today’s discounted valuations is a permanent loss in cash flow and future growth.
Is this likely for apartment REITs?
No, it isn’t, and therefore, we believe that this sell-off will be short lived.
Homeownership is not affordable for most people. It’s decreasingly popular among newer generations. And finally, even if you could and wanted to buy, it may not be practical because of the job market.
Renting Remains the Affordable Option
You have two options. You can rent, or you can buy. And the main factor to consider for most people is affordability.
There are many factors at play here: Income, home prices, interest rates, savings, debt, housing supply, etc. Each factor is then affected by multiple sub factors, and there are no simplistic relationships between them. At High Yield Landlord, we have published a detailed review of the Macroeconomic backdrop for apartment REITs, which you can read here.
In short, we believe that home affordability already is a massive problem for most people, and the lack of affordability will only grow larger in the coming years.
This is mainly because home prices are historically high due to housing shorting, and we expect a slow economic recovery with muted income growth. In that context, we do not believe that today’s low interest rates will be enough to keep affordability from declining.
Renting Also Is the Popular Option
From a financial standpoint, it’s often not feasible for people to own their homes. In addition to that, increasingly many people prefer to rent anyways as it suits better their lifestyle choices.
For example, it has been publicized that increasingly many people in their 20s and 30s prefer renting and living closer to city centers. We find it highly unlikely that urban millennials will suddenly change this preference because of the COVID-19 crisis.
This is a generation that values experiences over material possessions, and as such, they will still want to live in cities where things are happening. Moreover, living in a modern apartment community often comes with many more amenities: A swimming pool, gym, co-working, grilling stations, etc.
Finally, the Impact of a Job Location
Even if you could and wanted to buy in a more affordable area, you may still decide to rent and live in a more expensive city because that’s where most jobs are located.
We believe that the work-from-home narrative has been greatly exaggerated. Sure, if you never had to come to the office, then some would prefer to move to a more affordable area.
But the reality is that work-from-home is not a substitute, but only a complement to the office in the majority of cases. Increasingly many people will work from home, but only one or two days a week.
And contrary to popular beliefs, some of the fastest-growing job markets are expected to remain in big, expensive cities far into the future.
Historically Opportunistic Valuations
High-quality apartment REITs are expected to suffer mid-to-high single-digit negative cash flow growth in 2020. When you think about it, that’s really not much pain during what many consider to be “the worst of the worst crises.”
Moreover, it’s only temporary, and based on the three mega-trends discussed above, the long-term fundamental backdrop remains conducive for strong growth.
If you agree, then there are significant opportunities in the apartment REIT market right now. Most notably, we believe that luxury coastal apartment REITs have become deeply undervalued:
The market is focused on the current pain, but it has forgotten that the value of properties should be determined based on decades of expected cash flow.
Sure, there’s some pain today, but it isn’t severe, and most importantly, it’s only temporary.
Growth will return, balance sheets are the strongest they have ever been, liquidity is significant, and interest rates have now dropped to 0%.
These REITs already are turning from defense to offense with new acquisitions, property developments, and even share buybacks.
They have a history of always recovering and outperforming the market over long time periods:
Today, these REITs would need to appreciate by ~50% just to return to their pre-crisis valuations, but even that may not be enough because we now live in a 0% interest rate world. Before the crisis, these REITs traded at a ~100-basis point spread relative to the 10-year Treasury. Today, the spread is more than 300 basis point, and therefore, even if they appreciated by 100%, the spread would remain historically high.
While you wait for appreciation, you earn a >4% dividend yields which will likely turn into 2%-3% yields, after they appreciate by 50%-100%.
That’s why we are buying apartment REITs hand over fist at High Yield Landlord. They are some of the best investment opportunities in today’s yield-less world.
What Are We Buying?
The recent market crash has created exceptional opportunities. Many high-quality REITs are now offered at >8% sustainable dividend yields and have 100-200% upside potential in a recovery.
At High Yield Landlord, we are loading up on these discounted opportunities and share all our Top Ideas with our 2,000 members in real-time.
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Disclosure: I am/we are long AVB; CPT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.