By: Dividend Sensei
A friend of mine has made a fortune buying commercial real estate, including rental properties. Yet during the last correction when he asked me what he should buy to take advantage of the great values, his reaction to my recommendation was surprising.
Knowing he was fan of passive investing I recommended he buy VNQ, the Vanguard US REIT index ETF. It’s a great way to gain exposure to the entire US commercial real estate industry, a business model that was right in his wheelhouse. However he was leery of buying VNQ even though REITs are at their best valuations since the financial crisis. Like many people he believed that rising interest rates would crush REITs for years to come. In reality of course there is absolutely no correlation between REIT total returns and long-term interest rates.
Like many successful business people my friend gets nervous about stocks, even a broadly diversified portfolio of quality assets that literally make up the backbone of the US economy. As long as the economy is growing US REITs can’t go anywhere but up, especially from their multi-year low valuations. As a commercial real estate owner my friend’s entire business relies on an ability to value properties. He knows only to buy them if their cash yields(cap rates) are high enough to cover the cost of financing, as well as a risk premium (profit margin).
But here’s where my friend, and likely many investors, get tripped up. Even if you understand a company’s business model very well, and consider yourself a buy and hold investor, the instant liquidity of the market can be a double edged sword. For example take a rental property, or an apartment building. These can make great investments if you don’t overpay. And investors in such properties are usually very good at thinking analytically. Most importantly though the value of a rental property isn’t known on a second by second basis.
That’s because commercial real estate is known as an “illiquid asset”. Selling one of these can take several months, or even years. The value of a property can only be estimated very broadly until that property actually exchanges hands. That’s not very frequently because the transaction costs of selling a property usually run 3% to 7%. That’s both to buy and to sell, meaning that total transaction costs of buying and then selling a building or rental home to someone else is 6% to 14% of the property value.
This means that the turnover rate for such properties is very low. In fact most investors in commercial real estate aren’t looking to make a lot of capital gains, but rather just enjoy the income stream generated by rents. Or to put another way commercial real estate is dominated by long-term investors, and not short-term speculators. But the stock market is a very different beast.