Right now, REITs (VNQ) are at an inflection point and time is running out for investors.
In 2022 and 2023, REITs crashed because interest rates were rising and it caused investors to panic. On average, REITs dropped by 38% at their lowest point, and many individual REITs, including blue-chips like Crown Castle (CCI) and Alexandria (ARE) dropped by as much as 60%:
But now as we head into 2024, we expect the polar opposite and this should lead to an epic recovery across the REIT sector.
The Fed expects at least 3 interest rate cuts in 2024 and the market is predicting even more. Most major banks including Bank of America (BAC), JPMorgan (JPM), Deutsche Bank (DB), and UBS (UBS) are predicting big rate cuts already by mid-2024.
Some legendary investors are even more aggressive. To give you an example, Bill Ackman believes that we will see substantial rate cuts already in the first quarter of the year. Here is what he said in a recent interview:
"I think they're going to cut rates, and I think they're going to cut rates sooner than people expect. What's happening is the real rate of interest keeps increasing as inflation declines. If the Fed keeps rates in the middle 5s and inflation keeps trending below 3%, that's a very high real rate of interest. That's having a retarding effect on the economy.
Many businesses and many individuals have the benefit of fixed-rate debt. That fixed-rate, certainly for companies and for commercial real estate starts to roll off. So I think there's a risk of a hard landing if the Fed doesn't start cutting rates pretty soon.
The market expects sometime in the middle of next year. I think it's more likely probably as early as Q1."
This means that the window of opportunity to buy REITs at large discounts to their fair value is now closing.
The only reason why REITs were discounted was the rising interest rates, and therefore, if now remove this concern, REITs should strongly recover.
But don't take it just from me. The recovery has already started:
Rising interest rates are now turning into declining rates and as a result, the REIT bear market is now also turning into a strong bull market.
Here's why I think that this is still just the beginning.
Even after the recent rally, lots of REITs are still priced at huge discounts to their recent peaks.
Just to give you a few examples...
Crown Castle (CCI) is still priced at a 45% discount:
Alexandria Real Estate (ARE) is still priced at a 43% discount:
And BSR REIT (OTCPK:BSRTF) is still priced at a 45% discount:
And this does not take into account all the value creation that has happened over the past years.
In 2022 and 2023, the rents and property replacement values of REITs grew very significantly even as their share prices crashed.
Just to give you an example, BSR is down 45% since 2022, but its Texan apartment communities increased their rents by over 20%, and the REIT has also bought back a lot of shares and paid down some debt since then.
That's what most investors appear to have missed.
It is not just that share prices have dropped! On top of that, rents have also grown significantly, and REITs have created a lot of value by paying down debt, buying back shares, buying more properties, merging with other REITs, etc.
All of this growth and value creation of the past two years has been masked by the impact of rising interest rates, but as you have now removed this mask, this will finally be reflected in share prices.
And I predict that this will push many REITs to new all-time highs...
... If your share price is down 40%... even as your rents have grown 20%... and your count has been reduced... the upside potential could be very significant.
If this sounds improbable to you, then perhaps you should consider that REITs have existed for decades and they have historically always recovered from market crashes. Some of the past crises were much worse than the recent ones, and yet, they always seem to recover...
Moreover, the recovery is typically particularly quick. A recent study by Janus & Henderson found that REITs have historically generated a 130% average return in the 3 years following market crashes when they were priced at a >24% discount to their net asset value:
That's when they were priced at a 24% discount, but today, there are lots of REITs that are priced at even larger discounts.
We mentioned earlier that BSR is priced at a 40% discount and that's not even the cheapest REIT. Some other REITs like ... are priced at up to 50% discounts today - a 2x greater discount than what was used in the study of Janus & Henderson.
Here you may ask yourself:
Why do REITs always seem to recover?
There's a simple answer to this.
Good real estate is strictly limited in its supply due to the lack of available land and the cost of construction and capital. Today, as an example, it is simply too expensive to build. Construction costs have gone through the roof and the surge in interest rates has made most new development projects unprofitable.
However, the demand for good real estate is steadily growing over the long run. Simple economics would tell you that growing demand coupled with limited supply would result in rising rents, and eventually in rising valuations as well.
This is why it has always been a good idea to buy good real estate when it was discounted in the past. The market moves in cycles, but over the long run, good real estate sustains and grows its value due to these simple rules of economics.
Today, it is too expensive to build, and it will likely lead to undersupply in the coming years, more rent hikes, and eventually, this will lead to higher property values that will again justify more construction, especially if interest rates return to lower levels.
Closing Note
Today, we still get to buy good real estate via REITs at near the bottom of the cycle at steep discounts, but the window of opportunity is quickly closing.
REITs have created a lot of value in recent years and they are well-positioned to create more of it in 2024, but this has been masked by the recent surge in interest rates.
As interest rates are cut, the narrative will change and REITs will likely recover. I have positioned my portfolio to profit from this recovery with a heavy allocation to the most discounted REITs.
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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