If there is any sector that can exhibit Jekyll and Hyde tendencies at the same time right now, it is the real estate market. On the one hand, residential real estate has been on fire since the pandemic, as work from and a lack of supply drive up residential real estate prices. Homes in the Bay Area can sell for as much as $1 million above asking price. After closing on a home in Texas this week, the realtor told my investors and I that homes were selling for $100 thousand above asking price in Austin.
This is in complete contrast to the way the pandemic has upended commercial real estate. As people worked and shopped from home, offices and retail store sat empty with little foot traffic. Yet the “retailpocolypse” for mall and retail REITs started years before the pandemic as people’s habits as a whole started to shift to more online shopping. Now offices are the ones seeing a great deal of uncertainty with the future of work and office occupancy levels at stake.
Commercial real estate can encapsulate a number of different sub markets, it can include those mall REITs I mentioned but also office buildings, industrial property and storage warehouses. Yet since the pandemic first became widespread in early 2020, residential real estate has outperformed all of these sectors as a real estate class but that may be starting to slowly shift.
How I am Trying to Capture Returns
There are 3 ways I am playing the real estate market which are all varied in their approach. The first is through direct residential real estate. This means owning a home and renting it to a tenant. If things go right I would get my principal paid down through paying my mortgage and also price appreciation as the home price rises. Thanks to the Fed’s lower interest rates, I can take advantage of a lower rates and price appreciation to take equity out of the home through refinancing.
Within this space I have had a bit of luck as well as strategy. Owning properties which were more affordable but on the outer parts of large metropolises such as New York and San Francisco was a perfect unintentional positioning for the flow of buyers during the pandemic. In the case of my latest property, it’s a conscious play on the movement of people to cheaper and warmer climates such as Texas which I see as part of a broad and long demographic trend that will be played out over the next few decades. I’m not alone in this thinking, hedge fund manager Bill Ackman is also investing in Texas and BlckRock purchased 124 homes outside of Houston outright to use as rentals.
The other way I am attempting to play the residential real estate boom is through the iShares US Home Construction ETF (ITB). This ETF holds the largest residential home builders in the US such as D.R. Horton, Toll Brothers and big box home improvement stores such as Home Depot and Lowe’s. I consider it more of a pure residential and home improvement play in contrast to other home builder ETF’s like the SPDR S&P Home Builders ETF (XHB) which includes home furnishing consumer companies such as Williams Sonoma.
The third way I am capturing the rest of the market is through the Vanguard REIT Index ETF (VNQ). This index holds the largest REITs by market cap and many of these REITs hold property in sectors you wouldn’t consider hot right now, like those big box retailers as well as office space.
Counterintuitive Moves
ITB is up 22.11% year to date which reflects investors enthusiasm about the sector. Yet ITB has fallen 13% from its peak share price a month ago. At the same time, VNQ has risen 24.22% year to date and is up 6.36% in the last month.
What was driving the homebuilders ETF was logic that is easy to follow: home prices are going up, people are moving and renovating homes. Homebuilders stand to benefit directly by this jumó and selling their homes off. D.R. Horton revenues were up 43% and net income up 92.6% last quarter year over year.
Yet residential homes do not make up a large part of the REIT index at 13.19%. Of the REITs that do focus on residential real estate, they tend to own apartment buildings and higher density developments in urban areas, just the type of places that emptied out during the pandemic. Over 79% of VNQ is made up of specialty and commercial REITs, the type of real estate we may expect to be struggling right now but a look under the hood reveals something more interesting.
Below is the return of VNQ year to date and the return of the top 10 components of the ETF which make up about 40% of the fund.
VNQ – 24.22%
AMT – 20.65%
PLD – 26.71%
CCI – 25.79%
EQIX – 15.24%
PSA – 27.95%
DLR – 17.51%
SPG – 57.76%
SBAC – 12.94%
WELL – 22.47%
WY – 4.38%
Notice that much of the return is being driven by outsized movers like Simon Property Group (SPG) which is a bit odd when you consider that this REIT focuses on retail commercial property, just the sort of thing that the conventional wisdom tells us should be suffering right now because of Amazon and Walmart deliveries. But SPG has a distinct strategy, they focus only on class A luxury retail. These are upscale mall properties that sell a luxury goods, many at a discount. They call these premium outlets. A local example in the Nee York area of one of these properties is Woodbury Commons which lies about an hour north of the city and is often inundated on weekends by shoppers looking for deals on luxury goods.
Most shoppers of expensive goods don’t want to order them online. If you are devoting a lot of money towards something like shoes or jewelry, you likely want to see it and inspect it before you buy. Simon’s properties own locations that seem to capture this segment of the market and stand to benefit from the “revenge spending” that investors have been anticipating as things open back up.
In a nod towards this trend as well as a contrarian play on the death of retail, SPG and Target group have seen gains of 138% and 147% respectively since their lows during the market crash last March.
Changing Dynamics
The gains that commercial property is seeing now could speak to how investors are positioning themselves for the next developments in the real estate market. The return of customers to some types of shopping centers and workers to industrial properties will bode well for some particular types of REITs which is helping to propel the REIT index forward.
At the same time, the specter of higher mortgage rates, more homes coming to the market through the resumption of the foreclosures as well as a normalization of some commodity prices like lumber may produce an easing in home prices from their current stratospheric run. Lumber in particular has fallen almost 40% from the highs that it reached in early May. If these trends continue, it isn’t a far reach to think that we may have seen the peak of the current residential housing boom and prices may be able to take a breather going forward. This would be welcome news for prospective home buyers that have been shut out of the market by the bidding wars seen across the US.
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