Is Real Estate Dead?

"The best time to invest in a sector is when it's hated, valuations are low, and opportunities are abundant. This is the case of REITs today." - Jussi Askola, High Yield Landlord & Seeking Alpha Author

For better or worse, I subscribe to several research platforms, which blitz my inbox with news, market opinions, data, etc throughout the day. Most of it is noise, but one headline caught my eye...

"Why REITs Should Pummel Tech"

Now there's a contrarian opinion.

Turns out most of these bold headlines are a combination of clickbait and talking one's own book. In this case, the author did both masterfully. I clicked on the article and they were selling a REIT/dividend-based investment newsletter.

The author goes on to list several reasons REITs will outperform technology going forward:

• Tech has underperformed in the long run

• Tech is valued at extreme valuations compared to REITs

• Tech growth will slow down over time

• A COVID vaccine benefits REITs much more than tech

• Yield-starved investors will rush to REITs, not tech

One could easily counter with a strong and legitimate case against real estate. The death of brick and mortar retail, work from home movement, social distancing, and convenience of ordering anything you want via a few smartphone clicks.

It's no secret that post-COVID investors generally have an unfavorable opinion of real estate. I have had a few conversations about why we own real estate in portfolios. Just because an asset class is down for the year or out of favor, doesn't mean it's cause for abandoning ship.

I don't have a strong opinion either way on the future prospects of real estate vs. technology, but I do know that investing seldom deals in absolutes. Real estate is not dead nor is it poised to crush technology.

Here's where real estate stands year to date (as of 8/12/2020):

Source: YCharts

The above chart shows the Dow Jones US Real Estate Index (as of 8/12/2020). Despite a rough year, real estate has achieved ~9% return per year over the last 10 years.

Broad Asset Class

It's important to understand real estate is a large and broad asset class, which includes an array of sub-sectors. Some have been beaten up (retail, malls, office space), but real estate also includes sub-sectors that are thriving i.e. data centers, cell phone towers, storage facilities, apartment buildings, etc.

Local Economy

Adding another layer of complexity is the decentralized nature of real estate. What's true in Lubbock, Texas won't necessarily be true in Camas, WA or Tampa, FL. Compare that to the price of Apple stock which trades on a centralized market, it's the same price per share in New York as it is in California.

Indexes Naturally Rebalance

Major REIT indexes naturally reallocate to sectors that are in favor and away from sectors that are out of favor. Let's take a look at the FTSE Nareit All REIT Index holdings as of December 2017.

Pre-COVID sub-sector market cap (December 2017):

Source: NAREIT website

The above graphic shows the heavy weightings of office space, retail, and lodging/resorts in 2017.

Post-COVID sub-sector market cap (July 2020):

Source: NAREIT website

The above graphic shows the same REIT index through July 2020. Notice the dramatic drop in index weighting for office, retail, and lodging/resorts. Conversely, notice how infrastructure (cell phone towers, fiber cables, wireless networks) and data centers have become a larger share of the index.

Perhaps the most understated benefit of indexing is that we automatically own more of what's in favor and own less of what's out of favor. The areas that are seeing the most pain represent a smaller slice of REIT indexes.

COVID Knockout Punch + Repurposing

If brick and mortar real estate was on the ropes, COVID delivered a swift uppercut for the knockout. Owners of distressed properties, shopping malls with JC Penney's or Sears as the anchor tenant, will repurpose their investment. Remember, these are very sharp investors with billions of dollars on the line.

Simon Property Group, the biggest mall operator in North America, is talking to AMZN about repurposing Sears stores to become fulfillment centers.

J.C. Penney's could turn into an Amazon fulfillment center as well.

There's even talk of turning empty retail space into affordable housing.

It's tough to predict what normal human behavior looks like post-COVID. However, investors looking to dump their real estate holdings (REITs) because they are down year-to-date might want to reconsider. The indexes have morphed to owning what's desirable, while less desirable sectors are a smaller percentage of the index. Big institutional owners of out of favor sub-sector's won't sit idle while billions of dollars are at stake. Struggling properties will likely be repurposed to maximize their utility and provide a return on investment.

We are reminded of a scene from the Sopranos - Tony is driving his son AJ through his old childhood neighborhood. They pull up to an old church and Tony gives AJ some investment advice.

"Buy real estate AJ, God ain't making any more of it."