Over long time periods, REITs always have outperformed Stocks. During the past 20-year period, REITs generated nearly 2x higher annual returns:

The easiest way to outperform the market over the past 20 years would have been to load on REITs and wait. Real estate investing can be notoriously profitable over long time periods and REITs are a great example of that.

However, lately, the tide appears to have turned…

REITs (VNQ) produced abnormally low returns and underperformed the market over the past five years:

• 34% total returns in five years is about half of what REITs typically generate.

On the flip side…

• 82% total returns is roughly the double of what is typical for stocks (SPY).

Surely this cannot continue indefinitely…

The market has been very hot on growth and pushed the valuations of stocks to new historic highs. The opposite is true for REITs which have fallen behind and seen their valuation compress to deep discounts relative to stocks.

We believe that this sets REITs for a strong recovery in 2020 and beyond. Fundamentals are strong, valuations are very reasonable, and most importantly, the recipe to high total returns remains intact. Opportunities are abundant and we are heavily investing in discounted REITs.

Below we explain why REITs provide better risk-to-reward than stocks in 2020:

REITs vs. Stocks: Fundamentals

REITs own diversified portfolios of real estate investments. They earn steady cash flow from rents that are contractually guaranteed for many years to come.

Stocks, on the other hand, operate diverse businesses that may or may not generate steady cash flow. The sales are rarely contractually guaranteed, and therefore, the cash flow is much more volatile.

Historically, REITs grow their cash flow by roughly 5% per year and they do so very consistently. In comparison, stocks are very unsteady in their performance:

As you can see from the above table, stocks benefited a lot from the tax cuts in 2017 and 2018. Ignoring the tax cuts which were a one-time event, the fundamentals of stocks have been quite poor.

Growth has been disappointing and very inconsistent. This also is reflected in the stubbornly low worldwide economic growth, and as we enter the 11th year to an already extended economic cycle, growth is expected to decelerate even further.

We believe that REITs have more resilient growth prospects:

Organic growth: Leases have automatic 1%-2% rent increases per year. This already is agreed to with tenants. It does not change even in a recession. Moreover, REITs pay out only 70% of their cash flow on average. It leaves 30% for reinvesting and growing the portfolio. It results in consistent ~3% organic growth.

External growth: REITs source capital at cost x and reinvest it at return y to earn the spread in between. Some REITs particularly in the net lease sectors are very successful at this. Realty Income (NYSE:O) and STORE Capital (NYSE:STOR) are great examples. It adds another layer of growth that's mostly insensitive to the broader economy. As long as REITs can raise capital at a lower cost than the expected returns, they can grow accretively.

Combining both together, it is reasonable to expect steady and resilient 5% growth from REITs for years to come. I'm not so sure about stocks.

REITs Vs. Stocks: Valuation

A large portion of returns for stocks has come from earning multiple expansion over the past years:

Surely, this cannot go on forever. Right now, stocks trade over 25x earnings – which represents a 10x notch premium to their historic average. By all means, this is very expensive and eventually such high multiples always have crashed down closer to 15x earnings.

Without growth, it equates to a 4% earnings yield. Many market “experts” are forecasting stocks to return about this much in the coming years as growth slows down and valuation multiples start to contract.

REITs on the other hand have delivered historically low returns over the past years and this was partly due to valuation contraction. As a result, REITs are now historically inexpensive relative to other asset classes:

• FFO Multiple: REITs trade at 18x cash flow on average. This is below historic average when adjusted for the stronger REIT balance sheets. Note that leverage is currently at the lowest it has ever been.
• Price to NAV: REITs trade at a small discount to NAV at the moment. Historically, they trade at a slight premium.
• Yield Spread: REIT dividend yields provide an abnormally high spread over the 10-year Treasury rate.

From all three angles, REITs offer some upside from repricing at higher valuation and better margin of safety than stocks in 2020.

The REIT Formula to Superior Returns

REITs invest in income-producing real estate. And over long time periods, real estate has consistently provided very strong returns to investors. To this day, investors are able to purchase properties and earn 12%-15% annual total returns:

• Buy at a 7% cap rate
• Finance half of it with a 3%-4% mortgage
• Rents grow at 2% per year

And your leveraged total return fall in the 12-15% ballpark. Obviously, all property investments won’t perform this well, but when you are a REIT, you own 100s, if not 1000s, of these properties, and so on average, you deliver strong returns to shareholders over long time periods.

There are a lot skeptics out there, but this is exactly what REITs have achieved over the past many decades: REITs returned 14% per year over the last 20 years and beat all other asset classes. And given that fundamentals remain solid, valuations are historically low, and balance sheets are stronger than ever, we would not expect future returns to be materially different if you know how to pick winners.

REITs Will Return to Their Former Glory

What worked well in the past continues to work well today. Real estate remains a powerful asset class with steady cash flow, consistent growth, and market beating returns in the long run. REITs add another layer of returns through spread investing and economies of scale. And this is why they have historically provided such impressive returns:

In 2020, we expect REITs to return to their historic path of market outperformance. This does not however mean that you should go out and buy whatever REIT.

Some companies are overvalued, others are poorly managed, and some are even overleveraged. You need to be picky to earn these superior returns in 2020.

We invest in one out of 10 REITs on average. Presently, we are finding the best opportunities among smaller and lesser-known REITs that are out of the market’s radar.

A good example of that would be Hersha (HT) – a small-cap hotel REIT that pays an 8.3% dividend yield with a safe 55% payout ratio. Insiders are loading up on shares and the company has bought back ¼ of its shares over the past five years. Now that the recent portfolio repositioning is over, the company is refocusing its efforts on paying down debt which will ultimately lead to upside according to our analysis.