Commercial Real Estate (CRE) Investing: It's Not Too Late
Given that we're sitting in the 10th year of the longest economic expansion in American history, it is not surprising that we are subject to daily discourse between those who think we still have room to grow, and those who fear a contraction is imminent.
Commercial real estate (CRE) lives and dies with economic cycles, so many investors feel that they are unable to jump into CRE unless they have a bead on where the market is heading in the near term.
This task is even more challenging because of the constant chatter emanating from industry insiders, CEOs, financial analysts and anyone with something to say about the real estate markets. Frequently, market leaders will take diametrically opposed positions. As an individual investor, it can be difficult to understand what they see that you cannot.
We live in an information age, but access to information isn't enough. You must be able to mine that information for insights to generate better returns. Today, we'll help you figure out how to invest in CRE by showing you how to make sense of two opposing views in late-cycle commercial real estate investing. We'll also highlight a few real estate investment trusts (REITs) to home in on for growth and dividends.
Data is as of Jan. 22.
West Coast vs. the "Rest Coast"
Multifamily REITs – which, despite their focus, are considered commercial real estate, not residential – share an industry, but not necessarily the same goals or strategies.
- Essex Property Trust (ESS, $309.85), a San Mateo, California-based REIT, is betting heavily on high-dollar markets on the coast.
Michael J. Schall, the current CEO and President of Essex, advocates a continued reliance on multifamily buildings in supply-constrained West Coast markets, despite high valuations and a harsh regulatory climate. That's particularly the case in Tier 1 cities such as San Francisco and Los Angeles, where land-use rules and tenant protections are some of the strictest in the country.
Eric Bolton, Jr., President, Chairman and CEO of Mid-America Apartment Communities (MAA, $134.93), is taking a different approach. Instead of focusing on Tier 1 cities in high-end markets, Mid-America is looking to lower-cost-of-living areas in the Southeast, Southwest and Mid-Atlantic regions. These regions tend to have lower acquisition costs, offer more favorable business climates, and have the most room to grow in the long run.
Both companies are betting big on the future of the American multifamily housing market, and that future remains favorable at least going into 2020, as Bolton remarked in this Nareit interview.
"We all have to recalibrate our thinking a little coming off the historically strong trends of the last few years, but overall I think the apartment business remains in very good shape," he says. "Demographics, social trends, employment conditions and reasonable new supply all combine to provide conditions for apartment leasing that will support steady rent growth."
However, both REITs have very different approaches to reaching long-term growth. ESS (yield: 2.5%) is betting big on the continued economic dominance of the West Coast, while MAA (yield: 3.0%) plans to grow through cheaper but more numerous acquisitions in the heartland and elsewhere.
Pay Attention to Fundamental Indicators of Prosperity
Choosing the right market in which to invest seems like an insurmountable challenge, but there are tried-and-true metrics that investors can use to judge the multifamily market in any given geographic area.
The two key indicators you want to look out for are employment and population growth. The reason is simple: If people are unable to find jobs, they will be unable to afford housing. The same idea works for population growth: The fewer people you have competing for apartment space, the higher vacancies will be. Also, markets in areas with a declining population need to spend more on retaining tenants and marketing to new lessees.
Just remember: Even if these two indicators are solid, investors still must go deeper to find the true state of a market. For employment, ask yourself questions such as:
- What employers are working in the area?
- What are their long-term plans?
- Could they close or relocate?
All of these questions must be answered to determine the long-term health of a market. Markets that rely on one or two sources of employment, such as a major factory or a military post, tend to be more unstable than those areas with a more diverse employment base.
Going back to Essex Property Trust: ESS focuses strictly on multifamily properties in West Coast cities with strong employment growth, positive demographic trends and a multitude of demand drivers.
"Essex looks to invest in markets with the greatest long-term rent growth," Essex CEO Michael Schall told MultiHousingNews. "Each year, our research group looks more broadly at the housing supply/demand dynamics for many major U.S. metros, essentially to continually challenge our market selection criteria and portfolio allocations. At this point, on-going housing shortages, expensive housing alternatives and the exceptional growth in the technology industries continue to reaffirm our West Coast footprint."
Fundrise's West Coast eREIT (a public but non-traded REIT) is another option that follows a similar strategic plan.
Where CRE Fits in Your Portfolio
Commercial real estate provides investors with stable cash flow, appreciation benefits and substantial tax advantages when compared to other popular asset classes.
CRE also can help protect investor portfolios from volatility in traditional equities. The counter-cyclical nature of real estate – and multifamily in particular – allows investors to hedge against drops in the stock market. Even during a major housing crash, like that in 2008, multifamily assets in many parts of the country retained the same level or reduced vacancy, primarily because of increased demand for rental housing as people lost their homes to foreclosure or financial circumstances.
Over the long term, the value of real property in the U.S. – including commercial buildings – has always gone up. Studies have shown that while the equities market and passive real estate investments reach the same level of growth, managed real estate assets (such as REITs) tend to slightly outperform the stock market in long-term growth.
The tax advantages of CRE assets often have substantial positive effects on investor portfolios. Programs such as Opportunity Zones and regulations such as 1031 Exchanges allow for reinvestment of capital that would have otherwise been paid to the IRS. The ability to reinvest that capital helps savvy investors generate higher returns compared to investments without a tax-deferral period.
An example of a public REIT that aims to generate returns via Opportunity Zones is Belpointe's OZ REIT (BELP, $100.10). However, it's worth noting that while it's a pioneer in the space, it's traded "over-the-counter" on very thin volume of a few thousand shares per day. Adoption, if it comes, will take time, and this certainly is a play for more aggressive tastes.
In the private space, SkyBridge Opportunity Zone REIT is attempting a similar strategy. Skybridge CEO Anthony Scaramucci explained to Bloomberg why his firm is getting into the OZ space:
"There are 8,700 opportunity zones throughout the U.S. and we wanted to offer our clients a diversified portfolio across a whole section of that market; we wanted to be able to provide income during the course of the 10 years as we develop and mature properties, which will be cash-flowing; and then the liquidity aspect where at the end of year six we will be able to take the REIT public and people can make a decision if they want to stay and/or sell their shares."
Timing Isn't Everything
In many cases, investors feel they can create runaway profits by timing the market.
However, nothing is promised, and no outcome is certain. For instance, we are currently in the midst of a 10-year bull run that would have been inconceivable a decade ago, during the height of the Great Recession. Despite some negative indicators, such as the inverted yield curve that flashed a few times during 2019, many other positive indicators (such as job growth and consumer confidence) point to continued economic growth.
Many investors who waited on the sidelines in Year 7 or Year 8 are kicking themselves for mistiming. Their false belief that the market was overdue for a correction led to a situation where they lagged investors who pulled the trigger on investments regardless of historical trends.
That kind of timing isn't helpful. However, knowing where you are in the real estate cycle can help you locate profitable opportunities, and avoid losses. A focus on market fundamentals, and intrinsic value, is a much bigger factor in your long-term success than timing. It also is much easier to study the underlying fundamentals of an investment than to determine exactly when and how the market will go into recession.
"Investing is more an exercise in swinging a broadsword than using a surgical scalpel," says Charles Sizemore, principal of Sizemore Capital. "You don't have to time things perfectly so long as you're getting a reasonable price and, in the case of income-producing properties or REITs, getting a competitive yield. You should perhaps always keep a little dry powder around in order to take advantage of any major pullbacks. But if the numbers look good, you shouldn't be afraid to put your capital to work." He also points out that property rents tend to rise over time, and leases often have built-in rent escalators. So in the case of publicly traded REITs, this steady increase in rental income translates to steadily rising dividends.
Consider Realty Income (O, $76.89), which is probably the most "bond-like" of any traded equity REIT. Realty Income offers a decent current dividend yield of 3.6%, and it has raised that payout at a 4.6% compound annual rate since going public in 1994.
Why CEOs May Have Drastically Different Takes on the Market
From the outside looking in, it can be puzzling to see two CEOs, of similar background and pedigree, advocating for wildly different approaches in the commercial real estate markets.
For instance, when it comes to REITs, an ideological battle is being waged between proponents of big-money capital raises, and those who believe these funds are too cumbersome to generate optimal returns. The difference of opinion boils down to the fact that some leaders believe that carefully deployed "smart money" will generate higher returns compared to large funds that use their substantial capital and position in the market to force yields, rather than picking and choosing the very best opportunities.
These differing belief systems lead individual CEOs to "steer the ship" in wildly different directions, but with the same goal: maximizing returns. A larger firm might try to corner a particular property market to drive economic development, while a smaller, more agile firm might pick and choose individual opportunities in high-growth areas across the country.
In the markets, nothing is guaranteed, so it should come as no surprise that even the most knowledgeable and capable leaders may have different takes on how to generate the best returns for investors from CRE.
As an example of a successful "small ball" approach, consider the case of STORE Capital (STOR, $38.31), which yields 3.7%. STORE has successfully built a portfolio of more than 2,400 properties composed of everything from dental offices to auto shops. A nice aspect of this strategy is that trouble in a single property won't upend the portfolio. It's also worth mentioning that, with its focus on service businesses, STORE's portfolio is about as close to "Amazon-proof" as you can get.