Via SeekingAlpha.com

At High Yield Landlord, our investment strategy consists of buying real estate at a deep discount to fair value. This allows us to earn an 8% income yield while we wait for long-term appreciation:

Source

But, how do you buy real estate at a discount?

The answer – REITs.

REITs are publicly-traded companies that specialize in real estate investing. They allow investors to invest in real estate in the same way they would invest in any other sector – through the purchase of stock. REITs have historically offered…

  • High income
  • Consistent growth
  • And market-beating total returns

… to investors who knew what they were doing. However, if there’s one downside to REITs it’s that they often suffer from elevated volatility. Share prices go up and down every day, even if the underlying value of the properties remain stable.

Therefore, it’s not uncommon for REITs to trade at significant discounts or premiums to the underlying value of the real estate they own.

Right at this moment, there are REITs that trade at literally 50 cents on the dollar. In other words, you are getting $2 of real estate for every $1 that you invest just because the public stock market has underpriced the REITs.

Not every discounted REIT is worth buying because sometimes a discount is justified if the REIT is poorly managed or has poor prospects. But then at other times, the discount is simply the result of market inefficiencies.

A great example is Taubman Centers (NYSE:TCO.PK), a retail REIT which traded at an estimated 50% discount to the value of its real estate, and recently got bought out at a 100% premium to its share price.

ChartData by YCharts

Another example is HYL-holding Front Yard Residential (RESI) which we bought in early 2019. We bought it at $8.88 per share – thinking that the value of the real estate is at least $16 per share. While we wait for the gap to narrow down, we earn a 6% dividend yield.

The stock price had been appreciating, and recently, the company received a buyout offer from a private group for $12.5 per share – resulting in a 47.5% return in just one year.

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You cannot earn this type of return if you pay fair value for the real estate. However, when you buy at a deep discount to net asset value, you are essentially putting the REIT economics on steroids.

  • You earn higher income
  • You have more upside potential
  • You have better margin of safety

Buying discounted REITs allows us to outperform the returns of other traditional real estate investors – all while earning passive income and staying far away from tenants, toilets and trash.

How to Identify Discounted REITs?

While the idea of buying real estate at 50 cents on the dollar is compelling, you guessed it that it’s challenging.

There exists roughly 200 REITs today and only a minor portion of these represent attractive opportunities with a deep discount to fair value.

Currently we invest in ~20 REITs at High Yield Landlord representing just ~10% of the investment universe:

High Yield Landlord

Over time, we have found that the best REIT opportunities are often small-cap REITs, specialty REITs and / or foreign REITs. They are overlooked by most investors and present a lot of hidden gems for active investors.

Below we discuss these sub-sectors in greater detail and provide examples of opportunities.

Small Cap REITs

Most REIT investors focus on large cap mainstream REITs such as Realty Income (O), American Tower (AMT), and Prologis (PLD).

These large companies get all the media attention and regular coverage from analysts. However, because everyone is pilling on these few REITs, their valuations are stretched, and opportunities are rare.

What most investors ignore – there are four small-cap REITs for every large-cap REIT. These smaller and lesser-known REITs often present the best opportunities simply because they are ignored by so many.

It’s not uncommon to find high quality REITs trading at ~30-50% discounts to NAV.

MNR Real Estate (MNR) traded at a 25% discount to NAV throughout most of 2019. And this is despite owning one of the best industrial portfolios in the entire REIT sector, having a conservative balance sheet, and a track record of market-beating returns. We loaded up on the shares and since then the discount to NAV had narrowed down – up until the coronavirus crash took it back down to deeply discounted territory.

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Specialty REITs

Investors know how to analyze traditional properties. This includes apartments, retail, office and industrial. However, anything outside of that is more challenging, especially to generalist analysts who have no background in real estate.

As a result, specialty REITs are often misunderstood and discounted.

Medical Properties Trust (MPW), a hospital REIT, traded at a 40% discount to NAV back in 2018. The main reason for this discount was misplaced fears. Skilled nursing property REITs had dropped materially because rent coverage ratios were very tight and tenant bankruptcies were a real risk. Investors put the hospital REIT in the same basket and sold off.

In reality, hospitals enjoy up to 2x higher rent coverage ratios and were much better protected. Later on, as the market realized that it had mispriced MPW, it quickly doubled in share price. MPW has been our biggest winner over the past years and remains one of our largest holdings to this day.

Foreign REITs

Finally, investors rarely look abroad for opportunities. Investors suffer from “home bias” or the tendency to only invest in their local market.

With REITs, this is especially costly because the best opportunities are often in international markets which are even more inefficient and discounted.

In 2019, our best performer was a German REIT called DIC Asset, which once traded at a 30% discount to NAV. The reason why it was discounted is that the market misunderstood its business model that combined an asset management business with a wholly-owned portfolio. This unique strategy resulted in the best growth rates of the entire German REIT sector, and yet, the market was not seeing the value. One year later, the stock had returned 80% to investors. Again here, the recent coronavirus crash took it back down to discounted levels.

More recently, another HYL-holding named Northview Apartment, a Canadian apartment REIT, was acquired at a 12.5% premium to NAV. This company was once trading at a deep discount to NAV, and now investors are willing to pay even more than NAV for it.

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It shows how market volatility can benefit when you are able to identify discounted opportunities.

Bottom Line

By buying at below fair value, you boost returns by earning more cash flow and upside if and when the valuation normalizes over time.

By paying close attention to the net asset value of the properties, REIT investors can essentially buy real estate at cents on the dollar.

Paying a price below NAV is what has allowed me to outperform the REIT market ever since I became a professional analyst. Since inception of my first real estate dedicated account in 2016, I have averaged ~16% per year, compared to just 5% per year for REIT benchmarked during this time frame:

Note that this is a screenshot from my brokerage account at Interactive Brokers and I’m not cherry-picking dates. The blue line represents my account. The green line represents the most commonly followed REIT index.

I have been able to outperform because of the power of buying real estate at a deep discount to fair value. It’s just common sense that this strategy can result in outsized returns when implemented correctly.

Get Your Free Course To REIT Investing!

Here at High Yield Landlord, we just released a 10-Module Course to REIT investing for our 1,500 members. And you can get access to it for free with our 2-week free trial!

We are so confident in what we offer that we allow you to join us and decide within your free trial whether this service is something for you or not. You will get instant access to our Course to REIT investing, our 3 Portfolios, Top rated investments, Tracking tools, and much more.

You have everything to gain and nothing to lose.

Disclosure: I am/we are long MPW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.