Anyone who knows me knows I follow the real estate markets closer than my shadow follows me across the beach.
When I hear about economic health indicators like commercial real estate pricing, occupancy levels, and rent levels, I become giddy with excitement – no kidding.
I closely track every aspect of the real estate markets, because my portfolio is packed with REITs and small regional banks… which hold loan portfolios stuffed with real estate.
Obviously, finding individual REITs for less than asset value is a wildly profitable endeavor, which is why I've been doing it for decades now.
But when the entire sector trades at a discount, the market is telling you something very different.
See, for the last 30 years, REITs have traded at about a 2% premium to the broader stock market. In other words, the market is saying that investors seem pretty damn upbeat about the prospects for real estate, and stocks should naturally rise to match the value of those REITs.
And yes, generally speaking, the market has been correct in those cases.
History says it all: When REITs sell at a premium, about 86% of the time they move higher in price.
That's because investors correctly forecast the rising value of the underlying properties held by more liquid REITs, and so they invest broadly in the sector.
There you have it: Though the idea of a sector trading at a discount might seem appealing at first, you have to understand what the market is saying when the discount is widespread.
And there are a couple ways for this gap to close…
How to Hear What the Discount Is Saying
The first is one we just touched on: REIT prices appreciate to market value. The other is that private market values fall to the level of REIT pricing.
If you can't determine which outcome is more likely, that perceived “really great” discount buying opportunity… can lead to near-term losses.
I've tracked the discount relations to private market value for a long time now. I've developed what I think is a pretty good methodology for determining which scenario is most likely.
Very simply, it goes like this…
If real estate and REIT prices have been rising for an extended period of time, then the widening of the discount is usually telling us that prices are about to slow down, and may even drop back to the level of the current REIT valuation.
It's more of a “Sell” indicator than a “Buy” sign.
On the other hand, if prices have been falling and the discount in a given real estate sector widens, you are probably seeing the more psychologically sensitive liquid REIT market overshoot a stabilizing private market.
When that happens, get ready – it's probably time to start hunting for bargains in that sector.
With that in mind, let's look at today's market.
We see multifamily housing and office prices have been rising for years, and the discount to private market value is growing.
The market is saying that the move has gone far enough, and REIT buyers aren't willing to pay up for what it sees as inflated prices in these asset classes.
That means it's probably a good time to look elsewhere for potential bargains – unless you see an unreasonably good opportunity or special situation.
Here's an opportunity I think you could probably capitalize on this afternoon, if you want.
Thanks to Amazon.com Inc. (Nasdaq: AMZN), real estate prices have been dropping like a rock for several years now. Retail-focused REITs are trading at a substantial discount to the private market value of the properties.
This indicates how the more emotional REIT investors may be overshooting on the downside, which makes right now a good time to hunt for high-quality retail REITs that can be bought at a discount to the value of the property they own.
“Letting the discount speak” and understanding what it says will make you a better real estate investor. It's an unbeatable edge over the herd out there. Making the discount work for you instead of against you can lead to outrageous returns in the future.