Don't Be Afraid to Invest In Commercial Real Estate - The Bullish Case for Equity REITs
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Audible. There's more to imagine when you listen. Go to audible.com slash imagine and discover all the year's best waiting for you. Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I'm your host, David Stein. Today is episode 434. It's titled, Don't Be Afraid to Invest in Commercial Real Estate.

One of the things we've been focusing on at Money for the Rest of Us over the past few years is how can we make investing simpler? How can we understand the underlying principles, the drivers of performance, the basics of the economy, and how can we make it simpler?

how these different elements connect together so that we don't get caught up in the latest bad news, causing fear and causing us to want to run away or exit or sell a specific investment.

For example, here is a recent Wall Street Journal headline, Slow Return to Work Pummels Office Stocks. It's an article by Peter Grant. He writes, Share prices for some of the largest office landlords have dropped to near historic lows, reflecting a sluggish return to office rate and a rise in the number of investors betting that these stocks will keep falling.

It gives some examples of two publicly traded equity real estate investment trusts. One is SL Green, whose stock is about $22.50 per share, down from $140 back in 2015. Vernado Realty Trust is another REIT. It owns office buildings in San Francisco, Chicago, and New York.

It's priced at $13.13 per share, down from $67 per share in 2020. Both of those two public equity REITs are down 30% year-to-date. Vernado chief executive Stephen Roth said on the first quarter earnings call, we've all seen office stocks be crushed in a great concern about the future viability of the office.

If we look at occupancy rates or the percent of employees working in offices, it has stalled at roughly 50%.

More bad news for the office sector. I mentioned this a few episodes ago. I think it was a Plus episode for Plus members that Brookfield defaulted on $784 million of loans for two Los Angeles office buildings and walked away. Blackstone Group has a 26-story building in Manhattan.

1740 Broadway, between 55th and 56th Street. It bought that building in 2014 from Vernado, that equity REIT, for $605 million, at the top of the market. I saw one report that the cash flow for this building doesn't even cover the mortgage payment, and that Blackstone is going to have to put more equity in that building, more capital to keep it operating, or they'll walk away.

Now, maybe you own some equity REITs. Maybe it's the Vanguard Real Estate ETF or the iShares Core US REIT ETF. And you suffered through a 25% decline last year. And you see a report like this and it's like, we got to get out of here. It isn't that bad, really. But before I tell you why, let's look at some more potentially bad news. If we look at the $4.5 trillion report,

that makes up the commercial real estate mortgage market. About 38% is owned by banks. Life insurance companies have about 15% of those mortgages. And then another sector, 14%, is commercial mortgage-backed securities, which are a type of security that owns mortgages. They're like residential mortgage-backed securities, except they own commercial mortgages. The loans are sold-off securities

securitized and packaged into a bond. Commercial mortgages are a little different. Their average tenure is about seven to 10 years. And so you get a fair amount that mature.

For example, the Mortgage Bankers Association estimates that about $728 billion of that $4.5 trillion, or 16%, will mature in 2023. And with banks pulling back on lending and with some of these office buildings worth less than they were when the loan was taken out, that puts some stress in the sector, as we've seen with Brookfield, with Blackstone.

The thing about these mortgages, though, they're not just on office buildings. They're on all property types, multifamily, office, industrial, retail. And the same goes for equity real estate. If you own one of those equity REITs, for example, the Vanguard Real Estate ETF, only about 4.4% of

of its assets are office REITs. And only some of those would be in the major cities. They're spread all around the world. And when we look at these mortgages, they're the same way, very diversified. If we look at all the different sectors, for example, in that Vanguard real estate ETF, they have about 8% in data centers that house computers, 8% in healthcare REITs,

Around 3% in hotels. 13% in industrial REITs, so warehouses. 9% in multifamily. About 7% in self-storage. Another 5% in single-family residential REITs. 14% in telecom towers, cell towers. 2.5% in timber REITs.

Commercial real estate is more than just office buildings. And that percentage changes over time as the real estate sector changes. Tower REITs are becoming a bigger portion. Self-storage REITs are becoming a bigger portion, whereas office is becoming a smaller portion. And the same goes for mortgages. There's been some fear that...

The banks, especially the smaller banks, are going to get annihilated because this debt needs to be refinanced for these office buildings. The values are worth less and they're potentially exposed. But if we look at the 4,600 banks outside of the top 100 in the U.S., they own about 15 to 20 percent of all commercial real estate mortgages.

but only about 3% of their total assets are office loans. In other words, diversification not only protects us as individual investors, but it protects banks and it protects even investors in real estate unless they've niched down. If you're a office real estate investment trust focused on New York, primarily like Renato, then it's been a tough environment. But if you're a bank, a community bank, and you've lent,

and there are hundreds and hundreds of them, and you've lent to apartment buildings, you've lent maybe to some stores, you're okay. Because here's the other thing, when we look at commercial real estate, even though last year was a difficult year, all commercial properties, the value of the actual buildings have appreciated 42% since 2012, even though they're down around 15% in the past year.

Apartments are up 51% since 2012. Healthcare, 34%. Industrials, up 165%. Now, some sectors have struggled. Malls are down 16% since 2012, but that's a very small sector. Office has appreciated 5% since 2012. Structural

Strip centers, so a different type of retail sector apart from malls, are up 30% since 2012. And self-storage is up 200% since 2012. So some have done incredibly well, others have struggled, and that's just the nature of real estate. Now in the past year, they've all fallen. And the value of that real estate will continue to fall over the next few months as appraisals come in on those buildings. And

And that's just part of the normal cycle of real estate. But what's amazing, even in a sector such as offices that is struggling, there are elements that are doing well. If we look at rents in New York City, the Class A, the trophy buildings, they're actually up 2% since 2019. It's the non-trophy properties that have seen their rents fall the most.

Buildings built before the year 2000, for example, has seen rents fall 2% because with less office workers, given the hybrid nature of work, employees don't want to work in the office every single day anymore. And even though there's been mandates from some companies, some workers are rebelling. It's like they're just not.

I saw one report from JPMorgan Chase where they told managers have to be in the office five days a week now because the employees who are supposed to be in the office three days a week haven't been coming three days a week. And unless the manager's there to figure out who's coming and who came when, the

The employees aren't coming because people like that hybrid nature of work. And as a result, many companies have been upgrading their office space, consolidating it, making it smaller, but offering more amenities, which makes the trophy buildings even more attractive. And their values are actually holding up and their rents are. Before we continue, let me pause and share some words from this week's sponsors.

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ETF from September 30th, 2004 through December 31st, 2021. So right after equity REITs returned 40% in many cases in 2021. If we look at the annualized return then over that 17-year period or so, it's been 9.69% annualized.

5% was price appreciation, and then the income return from the dividend was around 4.7%.

In 2022, equity REITs, these publicly traded vehicles that own commercial real estate, they fell close to 25% in 2022. So if we look at the returns through earlier this week, May 19th, 2023, going back to September 30th, 2004, the annualized return has been 7.1%. So about two and a half percentage points

less. Still attractive though. The price return's been 2.6% and the income return's been about 4.5%. In other words, what can happen with real estate is the prices adjust based on the environment. As interest rates go up, that can push down the value of real estate because the cost of debt goes up for the property operators, so they're paying more interest. That

That can impact income a little bit. But generally speaking, the income return for REITs has been around 4.5%. If we look at the current dividend yield for equity REITs in the U.S., it's 4.2%. And then that dividend can grow over time as net operating income of the real estate grows, as the operators can charge more for rent.

On Money for the Restless Plus, we estimate returns for equity REITs, and our estimate's about 7.2% to 7.5% based on the current dividend yield of 4.2% to 4.5% and a 3% dividend growth rate.

If we look at Green Street, they're a specialist that researches commercial real estate. Over the next five years, they estimate that net operating income for commercial real estate will grow 4.5% per year.

And if that's the case, then that's potentially a return of over 8% for equity REITs if the valuations stay the same. Because with equity REITs, and it's the same for stocks, the long-term driver of return is the income, the cash flow, the dividend yield, whether that cash flow is growing and in terms of earnings growth or net operating income for real estate, for REITs, and then what are investors willing to pay

for that cash flow and cash flow growth as represented for stocks by the price to earnings ratio. When we talk about simplifying investing, going back to the principles, it's those drivers. Real estate can be incredibly complicated when we talk about CMBS, all the different sectors, the debt, servicing, et cetera. But at its core, as individual investors, we care about what the dividend yield is and whether it's expected to grow

And given the diversity of sectors within real estate, with the problem child right now being office buildings in downtown locations of major cities, a tiny percent of the overall universe of real estate, there's always something going bad in

in one aspect of real estate. For years, it was malls. And we see that in the returns since 2012. But now, Green Street's actually anticipating higher than average net operating income growth for retail store REITs. It goes in cycles. And it's those drivers. And it's one reason over the past year at Money for the Rest of Us, we're going to actually announce this next Wednesday on the podcast feed.

We're introducing and announcing a free email course that you can sign up for that will talk more about these return drivers and at the end introduce a new product that we're coming out with at Money for the Rest of Us that we've worked on for over a year developing the software to give you the tools to better analyze the performance of stock index funds.

and estimate the returns of stock index funds around the world, and to be able to look at the valuations and earnings charts. We're incredibly excited about it, and we want to share with you because we want to make investing simpler for you and give you the tools to be able to understand it yourself without relying on an intermediary, even an intermediary like me.

I saw a report from Cohen and Steers that talked about what drives the value of property, getting back to the principles. And it is a function of demand for space, supply and demand. How much supply is there of a certain sector of buildings, of real estate? And what is the demand? That impacts the price, as you would expect, the cost of

availability of credit is a driver. Can a borrower that wants to buy a building be able to get credit to be able to do that? And what's the interest rate?

Fourth element that factors into the value of real estate is investor return expectations. What are they willing to pay for that cash flow? Or in the case of private real estate, what's the cap rate? What is the net operating income divided by the price as interest rates go up? Those cap rates can go up, and that's one reason the value of real estate has fallen.

With public equity REITs, they've already fallen over 20%. They tend to lead. And now we're seeing on the private side, those valuations come down. They've fallen about 15% in the past year and potentially will continue to fall.

Every sector has a different supply-demand makeup. Within the office sector, because there's stress there, banks and others are less willing to lend on new construction, and so that is reducing the supply of new buildings, which can help firm up prices. So you get all of these moving pieces, and then you have new sectors.

I recently listened to a podcast that Nate Reit did, which is a real estate research arm, and they interviewed one of my former colleagues, Christian Buskin, who is head of real assets at FEG Advisors. And Christian mentioned that there's been...

the potential for a whole new category of public REITs, marinas, boat marinas, the ability of a particular operator, for example, to roll up a number of marinas and put them out as a public equity REIT. So there's a lot of innovation in this space and a lot of changes that impact the supply-demand picture. And so we don't want to get overly obsessed on whatever element of real estate is getting negative press.

We should have an allocation to commercial real estate, mostly through public REITs. But even if you just own the overall stock market, such as the Vanguard Total World Stock Market ETF, VT, it has 3% in real estate.

Given the consistency of the dividend over time, a 4% dividend yield, you might want an additional allocation. So for example, apart from my allocation to equity REITs as part of my exposure to index funds and ETFs, I have an additional 3% exposure of my net worth to public REITs and another 3% in private real estate funds. That's not counting my home and our cabin.

In our adaptive model portfolio examples of money for the rest of us plus, we have 5% in equity REITs, not counting the allocation that's part of the overall equity allocation. The one area of real estate that we want to be wary of right now is private REITs. We discussed those back in episode 414 earlier this year.

A private REIT is a vehicle that invests in commercial real estate, but it's not publicly traded. And so its price is not set every day by the consensus of buyers and sellers. Its price is determined by the sponsor based on the value of the buildings, the appraisal value. And those appraisals come in as a lag.

And that's why public REITs tend to lead private real estate because investors know that valuations are going to be marked down. And so the value of public REITs fall. And so they've already fallen over 25% leading private real estate. But within the private REITs, it's taking some time to do that as well as some of the private real estate funds. That is one advantage of the public REIT market. It tends to...

correct more quickly. And as a result, public REITs are more attractive than they've been in several years because their valuations have already been marked down. And so now we have a situation where the dividend yields 4%, and we can expect that dividend to increase at 3% to 4% over the next five years, generating positive returns for us

depending on what investors are willing to pay for REITs. Maybe they want to pay less, and so that could impact the returns, or maybe they want to pay more, and so the returns could be even better. But the cash flow is there. And by using an ETF to invest in public REITs, we get exposure to over 100 REITs.

equity REITs. VNQ has 165 holdings, which in turn own thousands of properties in many different sectors. And so we benefit from that. Now, we could use an active ETF. Some have done well, some have done not. I have one active REIT ETF in my portfolio, but we benefit from the diversification. Even a company like Blackstone that's running BREIT

and owns that property on Broadway in New York City that's underwater, they point out that less than 4% of their overall exposure in real estate is in offices. The problem child. So,

So even when we're hearing news that Brookfield has walked away from a building or Blackstone has a building under stress, it's just one small portion of their overall portfolio. And that's how we should approach commercial real estate, credibly diversified, using primarily public equity REITs.

Some investors want to own some private real estate. They want to get involved in owning a rental property, and there's nothing wrong with that. But recognize that's way more work. It's very different than investing in a diversified portfolio of incredibly well-run commercial real estate by professional managers. That's what you get when you invest in a public equity real estate ETF, an equity REIT. When you're investing on your own in...

Let's say you buy an apartment. It's very different. I've elected not to do that. I've toyed with it. We've tried, and it's just not what we like to do because it's too much work, even when you have outside management. But that doesn't mean it's a bad investment, and it can be incredibly successful. But if we're getting down to simplicity, getting down to basics, then start with the public equity REIT market, which is attractive right now. It

It's generating income. It's adaptable. It's flexible. It's innovative. And it can be a successful part of our long-term investment plan. That's episode 434. Thanks for listening.

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