Some prefer tech stocks.
Others prefer real estate investments.
I invest in both and you probably should too.
However, depending on a number of factors, I will at times invest more heavily in one than the other. Some of these factors include fundamentals, valuation, market sentiment, and interest rates, to name a few.
Right now, the popular bet is to invest heavily in tech stocks. Tesla (TSLA) is now up 400% year-to-date, Apple (AAPL) is now worth about $2 trillion, and other tech stocks such as Amazon (AMZN) and Facebook (FB) keep easily outperforming the rest of the market:
I’m doing the opposite. I’m gradually taking some gains off the table and reinvesting proceeds into real estate investments through the discounted REIT market.
I already have written a few articles on this topic and these are the responses that I get:
“You are crazy! Nothing beats tech stocks!”
“Real estate is dead! Tech is the future!”
“REITs cannot even collect rents. Sell!”
You get the point. Investors are very skeptical about REITs at the moment and selling tech to buy REITs is a very contrarian move. However, I expect this approach to pay off very handsomely in the recovery. Below, I explain why.
Sell to the Greedy (Tech). Buy from the Pessimist (REITs)
Markets move in cycles of fear and greed and as Warren Buffett would say:
“I simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
Right now, tech stocks are priced at historically high valuations. As an example, Amazon has seen its valuation multiple expand from 80x to 112x earnings today. Similarly, Apple is now priced at nearly 35x earnings, which is more than twice its valuation just a few quarters ago. Tesla is of course in a game of its own, priced at multi-100x earnings.
Yet, no one seems to really care in the tech space. Valuation does not matter anymore. There’s so much growth ahead of them anyways, right?
Well, not so fast. This sounds very much like what investors were saying about tech at the turn of the century, and we all know how that played out:
The boring, yet undervalued REITs returned 15% per year in the next 20 years, while tech trailed behind with much lower returns.
This was a period of explosive growth for tech because we started from such a low point. Yet, the rapid growth did not translate into high returns because the valuations were so high.
I fear that today’s excessive valuations will lead to another period of underperformance for tech in the coming decade. It’s one thing to price a small tech firm with explosive growth prospects at a high valuation, but it’s another thing to price a trillion-dollar firm with slowing growth at a high multiples.
Growth Will Slow Down
Tech firms experienced rapid growth in the recent past because they greatly benefited from the lockdowns. It essentially gave the digital world a temporary monopoly as it put all the real world businesses on pause.
Not surprisingly, Amazon saw its orders rise very substantially, and as people tried to fight boredom, they also opened Netflix (NFLX) accounts.
Many tech investors fail to see that this was a one-time special event and that recent growth is very unlikely to be matched in the future. It was an extraordinary situation that greatly benefited them, but as we now reopen the real world, these same tech firms will lose their monopoly, and face much greater competition from other real-world businesses.
Less people will order on Amazon and more will go shop in brick-and-mortar stores instead. As an example, Macerich (MAC) recently noted that many of its malls are back to 90% of pre-crisis traffic.
Similarly, less people will watch Netflix and more will go out to meet and connect with others instead. Less people will order food for delivery and more will go back to the restaurants.
As such, the recent gains in market share are not all permanent. As an example, I signed up for Netflix during the lockdowns, but now that I can go out again, I do not use it anymore and cancelled it. It’s reasonable to think that at least a portion of the recent growth was only temporary.
Moreover, the sheer size of these tech firms also will harm their growth.
Growing a trillion-dollar firm at a rapid pace is extremely difficult. Eventually, management becomes very difficult, and as more focused competitors start stealing market share, your growth starts falling apart because you are juggling too many plates at the same time. The size of Amazon-type companies is concerning to me. Size can be beneficial up to a certain point, but eventually you reach a point of where it brings more harm than good.
A Vaccine iI a Tailwind for REITs, but a Headwind for Many Tech Firms
It appears increasingly likely that a vaccine will be ready by 2021. We already are in September and so that really isn’t far away anymore.
The vaccine will speed up the recovery and allow people to return to their previous habits.
Since tech firms benefited from the pandemic, they also will suffer from its end. And vice versa for REITs. Since they suffered from the pandemic, they will benefit from its end.
The vaccine is a strong catalyst, especially for the beaten down retail and hotel REIT sectors, which remain priced at massive discounts to pre-crisis levels.
Rising Political Risk Will Hurt Tech Stocks
Depending on who wins this or the next election, there also could be significant consequences for tech firms. Many politicians are calling for more regulation and higher taxes for tech firms. Some even call for Amazon-type firms to be broken down in smaller firms.
At the very least, it seems likely that corporate taxes would go up if Joe Biden wins the election. Since REITs are tax-exempt vehicles, they are better protected. Regular C-corp businesses benefited from tax cuts in 2017 and outperformed REITs. We could now see the opposite happen in the coming years.
REITs: Don’t Sleep Through This Historic Opportunity
Whether you harvest gains in tech stocks or not, it does not change the fact that you should consider investing in discounted REITs.
We think that now is the best time in 10 years to invest in REITs. Here are five reasons why:
Reason #1: Discounted Valuations
Investors wrongly assume that REITs only invest in retail and office buildings. As a result, they fear that the growth of e-commerce and remote working will cause significant harm to REITs.
In reality, the great majority of REITs invest in other much more resilient property sectors that aren’t greatly affected by the recent crisis. Think for instance about warehouses, distribution centers, apartment communities, timberland, manufactured housing, farmland, data centers, cell towers, net lease properties, hospitals, medical office buildings, etc…
Yet, all these REITs get a bad rep and are now discounted because of the few struggling property sectors. REIT yield spreads are the highest they have ever been, at the only exception of the great financial crisis:
The last time REITs were so cheap based on yield spreads, they nearly tripled in the following two years:
REITs already are up by 50% since March, but we think that they have a lot more upside left.
We estimate that some REITs are undervalued by a factor of 2, despite not being greatly affected by the crisis. Some pay up to 6% dividend yields that are sustainable and growing through this crisis. As they return to fair value, they offer 50%-100% upside potential in the recovery.
Reason #2: Strong Balance Sheets
A lot of investors also believe that REITs are overleveraged time bombs. In reality, REIT balance sheets are the strongest they have ever been with low ~35-40% loan-to-value on average, a lot of liquidity, and well-staggered maturities.
Therefore, as overleveraged private landlords become distressed sellers, REITs will be ready to pick up the pieces at opportunistic prices.
Reason #3: Recovering Fundamentals
Rent collection rates dipped in April and May due to economic lockdowns. However, since then rent collection rates have quickly recovered and returned to near 100% for all sectors, except retail:
Moreover, REITs are now starting to collect the missed rent payments of earlier this year. This means that they will earn unusually high cash flow in the coming quarters.
Reason #4: Superior Resilience in a Slow Economic Recovery
Most REITs earn steady rent checks from 5-10 year leases. For this reason, they have historically outperformed the rest of the market during most recessions.
As we put this health crisis behind us, we may stay in a recession for a much longer period. Defensive REITs are well positioned to outperform in a slow economic recovery because they earn steady rent checks that are pre-agreed for many years to come.
Reason #5: Yield-Starved Investors in a Yield-Less World
Finally, and perhaps most importantly, we are now in a 0% interest rate world, which is a very big deal for REITs.
Treasuries pay nothing.
Traditional stocks and bonds are not much better.
In today’s yield-less world, the only remaining alternative to generate high and sustainable income is real estate, and by extension, REITs. The yield spreads are at a near all-time-highs, and as we put this crisis behind, we expect yield-starved investors to rush back to the REIT market.
Brookfield (BAM), a major private equity firm, expects investors to make significant changes to their asset allocations and buy much more real assets (and REITs) in the recovery:
Investors simply do not have any other alternatives to earn income in today’s yield-less world.
What will happen as all this capital hits the REIT market?
Prices will get bid up. Yields will compress. And yield spreads will normalize.
As this happens, many REITs have the potential to appreciate by 50%-100% over the coming years. While you wait, you earn high income from dividends.
I don’t know about you, but this sounds much more appealing to me than speculating with overpriced tech stocks.
Historic Market Opportunity!
The recent market crash has created exceptional opportunities. Many high-quality REITs are now offered at >8% sustainable dividend yields and have 100-200% upside potential in a recovery.
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Disclosure: I am/we are long BAM; MAC. 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.