Before Buying A Rental Property, Consider These REITs

Today, interest rates are so low that investors cannot earn sufficient income through bonds (VCLT) or Treasuries (IEF). Moreover, the stock market (SPY) has become extremely volatile, and increasingly many call it a bubble.

With this in mind, it’s not surprising that increasingly many investors are making the decision to buy a rental property in 2020:

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  • High Income: Treasuries pay 0.6%. Corporate bonds pay 2%-3%. But most rentals earn anywhere from 5% to 10% in income each year. That’s a lot in a yield-less world!
  • Low Volatility: Stocks are notoriously volatile, especially in the midst of today’s pandemic. Rentals are much more resilient. Their value does not change materially from one day to the next.
  • Leveraged Appreciation: Interest rates are today at the lowest they have ever been. And this means that rental investors can boost their returns with cheap leverage.
  • Inflation Protection: With the central bank’s printing presses going wild, many investors are concerned about accelerating inflation. Rental properties are among the best inflation hedges because shelter is a necessity that cannot be replaced.
  • Control and Peace of Mind: You control your own investment and make your own decisions. You do not have to rely on a management team that could be conflicted.

As such, rental properties can be very desirable investments, and this is particularly true in today’s highly uncertain environment.

Bonds pay close to nothing. Stocks appear overpriced and risky.

Yet, rentals offer high income, leveraged appreciation, and lower risk.

Put in this light, it’s a no brainer for many people. But before you make the final decision of buying a rental, we want you to consider another alternative, which is to buy publicly listed REITs (VNQ; IYR).

Rentals vs. REITs: Which is a Better Investment?

Before we dive into this topic, you should consider that I have invested in both. At a time, I used to only invest in private real estate and even worked for a private equity firm with $100s of millions worth of real estate investments.

Then as I learned more about REITs, I also built a sizable REIT Portfolio, which represents a large percentage of my net worth to this day.

So I like both, rentals and REITs, and understand their pros and cons.

Something that I have learned over the years is that there are better and worse times to invest in each of them. And right now, I believe that REITs offer much better value for investors. Therefore, I’m not buying rentals. I’m buying REITs instead. Here are three reasons why:

Reason #1: Historically Large Discounts to NAV

The rental market is hot right now. There’s a lot of demand and prices remain near all-time-highs.

The REIT market, on the other hand, has suffered significant volatility and valuations are today at near 10-year lows.

The small-cap REITs are the most comparable to rentals and they trade today at 20%-40% discounts to NAV. If you left the NAVs unadjusted, the discounts would jump closer to 30%-60%:

The NAV represents the market value of the underlying properties, net of debt. So when you buy a REIT at a 50% discount to NAV, that essentially means that you are getting real estate for 50 cents on the dollar.

It’s the same as buying two rentals for the price of one.

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This the main reason why we think that investors should favor REITs over rentals. They are deeply undervalued and many of them offer quick upside potential as they return to more reasonable valuations in the recovery.

Reason #2: Professional Management Matters More than Ever

The main downside of buying a rental has always been its management. You have to deal with the ugly three Ts: Tenants, toilets, and trash.

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Today, the management is even more difficult because of the pandemic.

  • Increasingly many tenants are skipping rent payments.
  • You may not be allowed to evict them.
  • Getting renovation work done takes loner than usual.
  • Making house showings may be dangerous to your health.

With this in mind, the value of having a professional management team is increasing. Once you have made your REIT investments, you can forget about it, sit back, and enjoy the dividends. You won’t have to fight with tenants over rent payments or deal with late night calls about clocked toilets.

REITs attract the best talent in the real estate space and the management is very efficient thanks to economies of scale. During the COVID-19 crisis, REIT management teams have achieved higher rent collection rates than private landlords. As an example, apartment REITs have consistently achieved ~97-98% rent collection, whereas private landlords are closer to 90%.

Hire a professional. You will thank us later.

Reason #3: Higher Returns – Lower Risk

The efficient market theory teaches us that higher returns can only be achieved by accepting higher risks.

But this is of course all theory. In real life, investors are highly emotional, markets are volatile, and prices do not always reflect fair value.

Because REITs are today so heavily discounted, we believe that they now offer greater return potential with less risk than rental properties.

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The lower risk comes from diversification, scale, professional management, liquidity, and lower leverage.

The higher returns come from unusually high discounts to NAV and the repricing to more appropriate valuations in the recovery.

Let’s look at an example:

AvalonBay Communities (AVB) is a blue-chip REIT with some of the highest quality apartment communities in the nation, an A-rated balance sheet with $1.75 billion of liquidity, and a multi-decade track record of always bouncing back and outperforming the rest of the market:

ChartData by YCharts

It’s much safer than buying one or two rental properties. Yet, because it’s now priced at an unusually low price, it has up to 50% upside potential just to return to its pre-crisis valuation.

While you wait, you earn a 4.3% dividend yield that’s sustainable and growing at ~5% per year on average.

Here is another example:

W.P Carey (WPC) is a blue-chip REIT that owns mostly industrial properties that enjoy long leases with strong tenants. It has kept earning near 100% of its rents throughout this crisis, has an investment-grade rated balance sheet, and a multi-decade track record of market outperformance.

ChartData by YCharts

Yet, it’s today priced at a 600-basis point spread relative to the 10-year Treasury. More commonly, it trades at a 200-basis point spread so that’s 3x more than usual!

If WPC doubled from here, its yield spread would still be historically high, and while you wait, you earn a 6.5% dividend yield that is growing and sustainable.

It’s very hard, or even impossible, to earn this type of return in the rental market. And this is precisely why we favor REITs at the moment.

Bottom Line

Now is time to load up on discounted REITs, but not just any REIT.

There exist more than 200 of them. Some are overleveraged. Others are poorly managed. Or even exposed to risky property sectors.

You need to be selective, just like how you are selective when buying a rental. You don’t buy the first one you visit and you conduct detailed due diligence before making an investment decision.

At High Yield Landlord, we invest on average in 1 REIT out of 10:

We believe that these are the best opportunities at the moment. They are offered at a 50% discount to NAV on average, pay a 6% dividend yield, and offer significant upside potential in the recovery.

Here at High Yield Landlord, we are loading up on deeply discounted real estate at the moment. Opportunities are abundant and now is time to act while the market is volatile!

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Disclosure: I am/we are long AVB; WPC. 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.