There May Not Be A REIT Opportunity Like This In Years

Real estate investment trusts (“REITs”) (VNQ) have dropped by about 30% in 2022…

… And to be fair, some of them probably deserved to decline in value.

Interest rates have surged to much higher levels, and some REITs happen to be heavily leveraged. A good example of that would be Industrial Logistics Properties Trust (ILPT). It is struggling to resolve its debt issues and may need to issue highly dilutive equity to survive.

We are also approaching a recession, and companies like Twitter and Meta Platforms (META) are already announcing mass layoffs, which surely will have a negative impact on some property sectors. To give you an example, office REITs like SL Green Realty Corp. (SLG) will surely feel the impact of an economic downturn.

But there are also some REITs that are doing just fine, and yet, they are down just as heavily or even more than the average in some cases.

A good example of that would be blue chip apartment REITs AvalonBay Communities, Inc. (AVB) and Camden Property Trust (CPT).

They are both considered to be blue chips because they have strong investment grade-rated balance sheets, long track records of significant outperformance, and they own class-A apartment communities.

You could objectively say that these are resilient companies and yet, they are down even more than the average of the REIT market. You will note in the chart below that they performed materially worse than the average of the REIT sector towards the end of last year:

After the recent drop, AVB’s share price is back at the same level it was in 2014, which makes little sense given that its assets have gained substantial value since then.

Let that sink in!

As a result, both AVB and CPT now trade at a historically large discount to their net asset value. We estimate that the discount is about 30% right now, which essentially means that you are given the opportunity to buy an interest in these apartment communities at just 70 cents on the dollar, and you get the added benefits of professional management, diversification, and liquidity for free on top of that.

Apartment community owned by CPT:

Apartment community owned by AVB:

I think that this is a historic buying opportunity, and so I will continue to steadily accumulate more shares in many phases. I am currently running a bit low on cash, but I recently made small additions anyway for our Retirement Portfolio at High Yield Landlord.

Why are they priced so cheaply?

The market is pricing them at such low valuations because it fears that rising rates will cause their cash flow and asset values to drop significantly.

I have already explained why I think that this won’t happen, but let me repeat it again:

Firstly, you need to consider that these apartment REITs have fortress balance sheets with low leverage and long debt maturities. Their LTVs are around 30% and they don’t have major maturities for years to come. Therefore, any impact will be limited and may not be felt for years from now. By then, these REITs may have also paid off a lot of that debt with retained cash flow and asset sales, which would reduce the impact even further.

Secondly, interest rates are only so high because of inflation, which is highly beneficial for these apartment REITs as it allowed them to jack up their rents. The rents of these apartment communities have grown by 10%+ over the past year, and even as rent growth moderates, it will still likely remain historically high. AVB grew its same property NOI by 13% in 2022 and CPT grew it by 15%!

So yes, interest expense will rise, but rents will also as a result of inflation, and the net impact is clearly positive. Inflation affects 100% of assets, but the rising rates only affect ~3-4% of the balance sheet each year if you have a 30% LTV and maturities are well-staggered.

Thirdly, the rising interest rates will make it more difficult and expensive for developers to enter new construction projects. As a result, there will be less new competing supply. At the same time, the demand for apartments will increase because higher rates make home ownership a less affordable option. It grows the pool of renters and in that sense, apartment communities can serve as a hedge against rising interest rates. Lower supply coupled with higher demand leads to even higher occupancy rates and rents in the long run.

Finally, something that everybody appears to overlook is that more than likely, rates will drop back down sooner or later. We have been in a 40-year trend to lower interest rates due to strong deflationary forces:

1. Aging Demographics
2. High Debt Loads
3. Income Inequality
4. Technological Innovation
5. Globalization.

We have had several temporary surges in interest rates during this time period and people are always quick to claim that the era of low rates is over. Yet, every time, rates eventually drop back down and reach even lower levels. Today, interest rates are up because the pandemic and war in Ukraine resulted in severe inflation, but this inflation won’t last forever and as we get it back under control, rates will also likely start to decline again.

Private real estate investors understand all of this and this is why the value of apartment communities hasn’t changed by much.

Cap rates have expanded a bit, but NOI has risen a lot as well, leaving valuations more or less intact.

Major private equity firms like Blackstone Inc. (BX) have been buying apartment communities left and right, despite the rising rates. Last year, they even bought out some public REITs, including Bluerock Residential Growth REIT and American Campus Communities, and these deals were made at materially higher valuations than those of today. This is one of the most sophisticated real estate investment groups in the world so don’t tell me that they don’t know what they are doing.

We think that the market has simply overreacted as it always does, and mispriced these apartments REITs due to fears that won’t have a significant and lasting impact on their fundamentals.

Today, there are still lots of demand for these assets from institutional investors that need this type of long-dated inflation-protected cash flow. A good example is UC Investments which just announced a $4 billion partnership with Blackstone and most of this will be invested in apartment communities.

Why invest today?

I was thinking about this topic a few days ago and filmed a quick video about it that you can watch by clicking here.

In short, I think that as we now get inflation back under control, interest rates will also return to lower levels as the Fed turns to stimulate the weakening economy.

These REITs collapsed in 2022 due to rising interest rates even as their cash flows kept on rising. Therefore, a return to lower interest rates should be an important tailwind for these REITs.

Bottom line

I will continue to accumulate shares of publicly listed apartment REITs while they are offered at huge discounts to fair value. I think that both CPT and AVB offer 30%+ upside potential, and, while you wait, you also earn a recession-resistant 3-4% dividend yield.

Essentially, this is a way for me to buy good real estate at 70 cents on the dollar, and it is even better than that because I get professional management, liquidity, diversification, and limited liability on top of that.

You can’t beat that by investing in rental properties.