International REITs: Overlooked Value And 5+ Percent Yields (NASDAQ:VNQI) (2024)

There are two key advantages to real estate that make it a popular choice for investors.

1. Real estate assets provide higher ongoing cash flow than stocks and bonds.
2. Real estate can easily be leveraged.

That said, these advantages aren't a secret and investors have bid up commercial real estate prices to the point where future returns are likely to be low in many popular markets. However, there are some pockets of value amid a mostly richly priced market in the US. I like to write about how the constraints and biases of large investors create opportunities in the market, and global real estate is a good example.

This is part one of my latest real estate series. Part two will cover how middle-class investors in favorable markets can make money from investing in rentals.

Why is real estate such a popular investment?

The median institutional investor has a target allocation to real estate of a little over 10 percent. The rationale for large institutions to invest in real estate is fairly similar to the rationale for mom and pop investors. Investing money in real estate yields predictable cash flow (typically 5+ percent rents after expenses), or can be leveraged up more than stocks typically can (about 3-1 for commercial deals).

Higher and more predictable cash flow off of their properties plus the ability to use more leverage means that successful middle-class landlords can often retire in their 30s, while institutional investors can ensure that they can satisfy their liabilities with less risk than they would otherwise have to take.

For a local example, Texas multifamily apartment properties are popular with institutional investors right now, partially due to rental yield but also because strong migration trends are seen as supporting the market.

Source: RED Capital

However, a quick look at these yields compared to where they were 7-10 years ago shows that multifamily real estate is not going to make you rich at this point in the cycle and that asset prices could come down significantly if cap rates revert to their previous levels without enough corresponding rent growth.

Tier 1 markets like New York and Los Angeles are yielding even lower with equal or fewer prospects for long-term rent growth. Investors are speculating on future price increases rather than on cash flow.

However, commercial real estate at large is still widely viewed as an attractive asset class because it's hard to get cash flow elsewhere with stocks and bonds yielding considerably less than real estate. As such, cap rates have continued to fall. They're now averaging about 5.6 percent nationwide for multifamily real estate. Real estate valuations are likely a little high when compared with equities, where earnings have benefited greatly from corporate tax cuts.

United States cap rates by sector

Source: Nareit

If we assume 3 percent rent growth, current valuations are implying about an 8.5 percent per year unlevered return for investing in commercial real estate, ignoring transaction costs. This is about 150 basis points lower than equities in my view (assuming US equities are at roughly 16x earnings and long-run profit growth of 4 percent as of my last check). Cap rates would need to come up to about 6.5-7 percent to equalize the difference, which means CRE prices would likely need to come down 10-15 percent to achieve parity with equities.

To this point on transaction costs, real estate assets have the disadvantage of being illiquid. Contrary to what many market participants seem to think, research shows that merely taking illiquidity risk doesn't improve your risk-adjusted returns. In fact, illiquid assets should be priced lower than liquid assets to reflect the unique challenges of owning assets that are hard to turn in to cash without significantly affecting overall returns.

To compensate for illiquidity, I model a 250 basis point per year discount needed to invest in illiquid assets. This discount is meant to reflect the higher transaction costs of investing in real estate. For example, the 5 percent broker commission to sell the property and time spent on the market/negotiating with buyers prevents you from realizing the full extent of your returns. This discount also reflects the higher cost of financing that will be imposed on you due to the difficulty in liquidating your collateral for lenders, as nonrecourse commercial mortgages typically average about 250-300+ basis points per year more than the rate you could get in the futures market to take equity, bond, or commodity risk.

The market usually has priced a discount in the past but doesn't seem to be pricing any illiquidity discount at all at the present moment. High prices for illiquid private assets like real estate and private equity investments have led some to conclude that their current valuations may be a bubble.

Modeling a fair return for real estate assets and REITs

It is my belief that commercial real estate prices have been driven up by the constraints of income-starved institutional investors. The US commercial real estate market is currently worth about $15 trillion, which sounds like a lot until you realize that global pension funds and insurance companies have about three times as much money as all the commercial real estate in America is worth. These institutions will collectively need to take boatloads of risk to hit their return targets over the coming decades. US real estate is seen as a safe bet.

Investors are simply not pricing enough of a discount for illiquid assets located in the US, especially given the fact that you can invest in real estate globally but most investors refuse to venture beyond a 30-minute radius of their home. This is another exploitable bias that investors have called "home bias."

Additionally, real estate assets tend to suffer from the concentration of risk, whether its the risk of investing in a given market, financing risk, or systemic, industry-wide risk.

To test this a somewhat, I ran some numbers in Portfolio Visualizer to see where REIT returns stack up against commercial real estate returns. What I discovered from building this model was that international diversification works very well in REITs. If my hypothesis that institutional investors are bidding up the prices of US commercial real estate is correct, then this will help you diversify most of that risk away.

Source: Portfolio Visualizer

As you can see here, since the inception of both funds, you're able to get about a 10-15 percent reduction in risk by combining domestic REITs (VNQ) with international ones, as represented by the Vanguard Ex-US Real Estate ETF (NASDAQ:VNQI). The combination that minimized the risk was 55 percent international REITs and 45 percent US REITs. This allows you to get a higher dividend yield, less risk, and a return that isn't dependent on US real estate values or the US dollar continuing to rise. VNQI allows you to take advantage of the appreciated dollar to buy real estate in various global markets that are now cheap in dollar terms. Once you take out the effect of the strong dollar over the last 7 years, VNQI's track record is honestly impressive. Currencies have a tendency to revert to the mean with time against the world at large, so not putting all your eggs in the long dollar basket is a superior move here.

Source: Marketwatch

Foreign dividends are a little unpredictable due to foreign exchange fluctuations and payment schedules, but VNQI appears to be yielding roughly 5.1 percent at the moment. VNQ yields 4.3 percent, so putting them together means you're estimated to get 4.75 percent in income on your money over the next year. I modeled FFO growth of about 4 percent in both markets, which is lower than REITs have been able to deliver in the past. Note that dividend yields are lower for REITs than cap rates are due to the fact that REITs typically use some leverage to boost their returns and are able to reinvest some money to expand their balance sheets (REITs are required to pay 90 percent of their taxable earnings to shareholders, but this is a much lower number than FFO/cash flow due to tax breaks given to real estate investors). This makes for higher capital gains and slightly lower dividend yields.

A note on ETF dividends– they're not going to be as consistent as stocks as the underlying cash flow is often seasonal. I get the fear about not wanting to dip into principal, but funds like this allow you to be more diversified at the expense of a certain quarterly dividend. While certainty is good, you don't want to sacrifice the risk-adjusted return of your portfolio to achieve dividend certainty. The uncertainty of dividends due to foreign exchange fluctuations and payment schedules is a better risk to take than overpaying for too little cash flow.

A global portfolio of REITs seems to have a competitive advantage over private real estate for two reasons.

1. Real estate valuations are lower abroad than they are domestically due to the dollar being strong. If you're willing to take a little FX risk (meaning split your portfolio between domestic and international REITs rather than being 100 percent in either), you can get about a 100 basis point higher return per year on average in my view going forward, with additional upside if the dollar reverts to the mean. Introducing a little FX risk to your portfolio isn't bad in my view because it helps diversify your broader portfolio against other risks, like domestic inflation.
2. REITs can borrow cheaper than most commercial real estate investors can. The larger and more creditworthy the REIT, the greater the advantage. There's a significant spread between what a nonrecourse commercial mortgage would cost and a corporate bond issue for an investment grade REIT costs, for example. Commercial loans are also going to cost more than residential loans on average due to the lack of government subsidies and difficulty in liquidating collateral. It's very possible that institutional investors are collectively willing to overpay for nonrecourse financing.

I will note that when I build out my full mean-variance models, REITs tend to win small portfolio allocations if at all. Still, REITs are a good choice for 401k accounts due to their high level of income and imperfect correlation with equities. Additionally, if you want to retire and need to have a high level of dividend income each year, a REIT allocation is one of the safest ways to do so.

If you just want to maximize your risk-adjusted return in a taxable portfolio, your portfolio will look more like the leveraged risk parity portfolios that I've written about a fair deal in the past. You can use volatility targeting and risk/return factor analysis to improve the strength of your market forecasts. Also, I do believe that good REIT analysts can beat the sector average returns due to the idiosyncratic nature of the sector. There are a few great analysts on this site that cover individual REITs, for those so inclined.

Conclusion

For taxable accounts, REITs tend to win fewer allocations in the optimization models but are still a decent investment choice. I think there are much better ways you can trade if you're completely unconstrained (maybe with the exception of a small stake in VNQI to hedge domestic inflation) but you're not shooting yourself in the foot by having some money in REITs. That said, global REITs seem to be a more compelling value than domestic ones. VNQI is a buy for any investor looking for REIT exposure.

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Logan Kane