Do a quick Internet search for “rental property investing” and you’ll find tens of thousands of results.
Hundreds of books have been written on the topic. Untold hours of videos have been uploaded to YouTube about it. Countless gurus have made a living from pitching the dream of retiring on the cash flow from a rental property portfolio.
You might think we are about to criticize the whole idea of rental property investing and living off of the cash flow from one’s portfolio.
Actually, no. Not really.
Real estate has made numerous savvy landlords into millionaires. The asset class has many positive qualities: defensiveness, inflation protection, tax benefits, etc.
But perhaps the quality we find most admirable in the standard, buy-and-hold form of rental property investing is the mindset of a landlord.
We have discussed in many articles in the past why we believe real estate investment trusts (“REITs”) (VNQ), publicly traded vehicles for investing in commercial real estate, are a better way to gain exposure to real estate than direct ownership of rental properties in most cases. That’s not what this article is about.
Instead, we want to highlight the benefits of investing in publicly traded stocks, especially REITs, with the mindset of a landlord. In multiple ways, bringing the mindset of a landlord into the medium of stock investing gives investors the best of both worlds.
Below, we pitch three ways stock investors ought to act more like landlords:
1. Do Your Due Diligence
The first point is also the simplest, so we won’t belabor it.
Do your due diligence. Don’t skimp on upfront research before making a purchase.
Savvy landlords know this. How many real estate deals have fallen through because, though initially attractive on paper, the buyer discovers a major issue with the foundation, plumping, or roof during the due diligence period?
It is easy for long-term stock investors to look derisively at the many newbie investors who dumped their savings into the latest cryptocurrency or Wall Street Bets pick like GameStop Corp. (GME) or AMC Entertainment (AMC), knowing next to nothing about the underlying assets, only to watch the value of their money halve, or worse.
But how many of us have bought a stock we had just learned about, feeling an inflated sense of confidence based on the 30 minutes of reading we’d done on it, only to get clobbered by the manifestation of some risk that we would have known about if we’d done a thorough job of due diligence?
Just like buying a rental property, when buying shares in an individual company, there are lots of things to know and consider. There are risks to be aware of.
How many mistakes would be avoided if stock investors had to undergo a mandatory, multi-week due diligence period before buying a stock?
2. Buy At A Good Price
A savvy real estate investor will know that the money is made at the time that you buy a property. That is because the price you pay for a property determines the return on investment in terms of both the cash flow received from it and the proceeds you eventually get from selling it.
This is a very different mindset than the one commonly found in stock market investing, wherein investors are advised that “time in the market” is better than “timing the market.” The idea is that, in the long run, it doesn’t really matter if you overpay for stocks, because stock prices typically go up over long periods of time. Thus, simply being invested and not missing out on the gains is more important than waiting around in cash and trying to buy at the exact bottom.
Admittedly, for index funds, wherein the constituent holdings change over time, this saying mostly holds true.
But for individual stocks and REITs, it isn’t very good advice, in our opinion. That is because, unlike a broad index that virtually tracks the entire economy, an individual company can absolutely go down or be rangebound for long periods of time.
To translate this back into landlord terms, it would seem ridiculous to tell a rental property investor who purchased a house in 2006, right before the housing crash, that “time in the market is better than timing the market.” All that does is provide an excuse for the mistake of ignoring the fundamentals and overpaying for an asset.
It’s useful to remember that shares of stock are simply ownership stakes in a business, and REIT shares are ownership stakes in a real estate investment company. Individual stocks, then, are akin to individual rental properties. It is entirely possible to overpay for them!
For stocks and REITs just as for rental properties, the returns you get ultimately depend on the price you pay.
3. Ignore The Market Price After Buying
This is perhaps the most crucial point.
After a property has been purchased, a landlord typically ignores the market value of the property for the most part. Their plan is to hold the property for many years, if not indefinitely, so why would they care what price someone else would be willing to pay for the property at the current moment?
What landlords care about instead is that the property is performing well and that it is generating as much cash flow as possible.
It’s easier for landlords to ignore the market value, of course, because there is no rental property exchange where each house is listed, showing the daily fluctuations in market price. Landlords would have to call a real estate agent and ask for a market value report using the latest sales comparables to get a good idea of the up-to-date market value. This naturally leads to less anxiety about paper gains or losses and less temptation to sell prematurely.
Imagine an owner of a handful of rental properties close to a college campus during the Great Financial Crisis of 2008-2009. The value of those properties may have dropped along with the national average in home prices through that time…
After all, even if the cash flow doesn’t falter, the sheer lack of cash and liquidity in the market at the time likely means that the price the landlord could get for the property would have dropped. But if the landlord remains confident in those properties, then why should he or she care?
If the landlord believes his tenants’ ability to pay rent hasn’t been impaired, and even if it has, the college isn’t going away nor is enrollment going to meaningfully decline, and the properties are in a desirable location in close proximity to the campus, then why should he or she spend any time worrying about the current market price?
In other words, if the landlord has done his/her homework and bought at a good price, and if they intend to hold this valuable asset for a long time, then what someone else is willing to pay, or whether anyone is presently willing to purchase the property at all, simply doesn’t matter.
For buy-and-hold landlords, fundamentals are supreme.
Not only do the fundamentals determine the cash flow, but they also determine its fair value. This fair value can be separated from the market value for a short period, to the upside during periods of euphoria and to the downside during periods of despondence and/or liquidity crunches. To borrow the saying of Benjamin Graham:
In the short term, the market is a voting machine. But in the long term, it is a weighing machine.
A valuable asset will retain and grow its value over the long term, whether that asset is a rental property or a stock.
But just as for residential real estate, commercial real estate and the REITs that own it can see their market values separated from their fair values for short periods of time.
Sometimes this refers to euphoric rallies that get ahead of themselves, and other times it refers to despondent selloffs until market prices reach rock bottom.
Just looking at the charts above, it would certainly appear to be the case that commercial real estate and REIT prices are slumping in a state of despondence, which likely means that market values are trading below their long-term fair values.
But, in any case, the point here is that it is not only possible but prudent to invest in stocks and REITs with a landlord’s mindset.
- Do your due diligence.
- Buy at a good price (i.e. under your estimate of fair value).
- Ignore fluctuations in the market price after you’ve made your purchase.
Treat the stocks and REITs you own in the same way as a landlord treats the rental properties he/she owns. Pay attention to the fundamentals and let the market price take care of itself.
Just as for rental properties, the fundamentals are what ultimately determine not only the company’s cash flows but also the fair value. And though the market value whipsaws up and down based on the prevailing investor sentiment of the moment, it always follows the fair value over the long term.
Think of the often-used illustration of the dog walking on a leash. The dog runs this way and that but is ultimately tethered to its human, and thus the overarching trajectory of the dog’s movements is in whatever direction the human is walking.
Bottom Line
At High Yield Landlord, we love the diversification, scale, liquidity, and expert management that are offered by REITs, but we are wary not to allow the daily liquidity of publicly traded stock prices trick us into over-trading.
We try to invest in REITs with the mindset of landlords by:
- Performing deep diligence on each of our picks (not to mention the many REITs that don’t make it into our portfolio!)
- Buying REITs at a good price that is well below our fair value estimates
- Ignoring the emotional swings in market price after we’ve made our purchase
Unfortunately, while dislocations of market price to fair value are truly short in the grand scheme, they can seem tortuously unending while enduring them. We think we are currently in one of those periods of dislocation right now.
Here are two examples.
Two of our favorite REITs are the Sunbelt Class B apartment owner BSR REIT (OTCPK:BSRTF) and the Class A life science owner/developer Alexandria Real Estate Equities (ARE). They have gone nowhere in the last three years.
Over that time, the fair value of both REITs (as measured by rent rates, net operating income, net asset values, funds from operations, and a number of other metrics) have soared by 30-50% or more.
The fundamentals, as measured by a number of objective metrics, have dramatically dislocated from market sentiment, which is driven by irrational fears that higher interest rates are somehow going to cause these two lightly leveraged and cash-rich REITs to collapse.
At High Yield Landlord, we are happy to take advantage of such dislocations as this.
It takes patience and discipline to invest in REITs with the mindset of a landlord, but in the long run, investors will be richly rewarded for it.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
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