Barry Sternlicht is one of the most influential investors of our time.
He founded Starwood Capital Group back in 1991 and grew it into one of the world’s biggest private equity groups, managing over $120 billion of capital, and rivaling the likes of Blackstone (BX) and Brookfield (BAM).
To this day, he still remains the company’s CEO and Chairman and is regularly invited on various televised interviews to discuss his latest thoughts on real estate markets because of his exceptional track record in this sector.
Just recently, he went on the show “Bloomberg Wealth” to share his latest thoughts, and here’s the main takeaway that caught everyone’s attention:
“I like to say, it is a hurricane over real estate. Right now, we are in the category 5 hurricane and it’s sort of the a black cloud hovering over the entire industry until we get some relief of some understanding of what the Fed’s going to do over the longer term.”
He is here, of course, referring to the impact of rising interest rates on real estate. All else held equal, higher interest rates would lower the value of real estate given that it would lead to an increase in cap rates and also reduce the cash flow by increasing the interest expense.
Mr. Sternlicht sounded very pessimistic in this segment of the interview, and it led many of you to ask me how this relates to the real estate investment trust, or REIT, market (VNQ).
It may seem that if real estate is facing a hurricane, then REITs would suffer just as much, if not more. But that’s not actually the case because of how differently REITs are valued in today’s market.
Right now, REITs are priced at exceptionally low valuations as if the real estate had crashed already – whereas private markets have been very slow to adjust. Just to give you a simple example: BSR REIT (OTCPK:BSRTF) is today priced at a 6.5% implied cap rate, but similar Texan apartment communities are still selling at a 4.5% cap rate in the private market. Its valuation represents a 37% discount to its net asset value, or put differently, its equity is priced at 63 cents on the dollar:
|Public REIT market (BSR REIT)||Texan apartment community|
For this reason, Mr. Sternlicht is actually very bullish on REITs even as he seems to be questioning today’s real estate values.
Here is what he said in a CNBC interview about REITs just a few months ago:
“By the way, when credit comes back, you are gonna see REITs take off. REITs are on sale. There are some unbelievable bargains in REITs. We did the same thing during the pandemic. We bought a dozen stocks all over the world and we had a 70% IRR on that stuff. We are already buying some stuff in the public market because I do think that rates are going down.”
He then added that:
“I think that the credit market is right and Powell is wrong. I don’t think that he is going to have a choice. He gets to lower those rates because inflation is coming down… I don’t know why the Fed has this credibility today when they didn’t get it yesterday.”
So put simply, he appears to believe that REITs are too cheap whereas real estate is potentially a bit too expensive.
The middle ground is probably where fair values will land as we get inflation back under control and interest rates return to lower levels.
Cap rates will expand a bit, but not as much as the REIT market is today’s pricing, and this is why they have become very opportunistic.
To get back to the example of BSR REIT, the cap rates of its assets may expand to 5% or even 5.5%, but it trades today already at a roughly 6.5% cap rate and as its rents keep on rising, its shares will soon trade at closer to a 7% implied cap rate unless its share price rises from here.
So there is significant margin of safety and this is why Mr. Sternlicht appears to be so bullish on REITs at today’s valuations.
They have overshot to the downside and now offer significant upside potential in a future recovery.
He added in this new interview with Bloomberg that the fundamentals of real estate are actually quite strong:
“We didn’t really cause this problem. Banks hadn’t overleveraged their loans, they hadn’t stretched their loan-to-values, and the underlying fundamentals in most of the asset classes in real estate are okay right now in the United States. The apartment market, the industrial logistics market, the hotel markets, those are all in good shape.”
Based on these comments, it would seem that he is most interested in REITs operating in these property sectors and he is correct to point out that there are “some unbelievable bargains.”
I mentioned BSR earlier but that’s just one example among many others.
Let’s look at one more example:
I have mentioned this one quite a few times here on Seeking Alpha and for a good reason: it is the cheapest blue-chip apartment landlord that’s publicly listed. It is the biggest landlord in Germany, owning a portfolio worth about $100 billion, and it is today priced at just 1/3 of its net asset value, and that’s despite having the characteristics of a blue-chip company (strong management, great track record, investment grade rated balance sheet, unique strategy creating shareholder value, growth in rents, etc.).
The market appears to think that its net asset value is inflated, but in reality, it represents just €1,500 per square meter of implied building value, which is far less than what it would cost today to build these assets, and Germany happens to be severely undersupplied with occupancy rates at near 100%.
Vonovia just recently sold some assets to CBRE Group (CBRE), which is one of the most sophisticated real estate firms in the world at just a small discount to fair value, and then used the proceeds to buy back some debt at an 11% discount, reducing risks and creating value for shareholders.
They plan to keep doing more of this up until interest rates return to lower levels and in the meantime, their rents also keep on growing annually by 3-4% because of how rents are regulated in Germany. (Note that rents did not drop even in 2008-2009 in Germany)
Therefore, the risk-to-reward seems extremely compelling to me. The company will be fine even if interest rates remain high for years. Its net asset value will likely come down a bit, but even if it dropped by 30%, it would still be severely discounted. Today, its NAV per share is around €55 per share but the shares trade at just €20.
On the flip side, if interest rates finally return to lower levels, then the shares could rapidly rise by over 100% from here and this is why the risk-to-reward seems very asymmetric at these valuations.
Apartment communities are not going anywhere, and they are just badly mispriced by the public market.
When Mr. Sternlicht talks, it is worth listening.
He became a self-made billionaire by buying real estate on the cheap, and today he is talking about “unbelievable bargains” in the REIT sector.
If you want to participate in this opportunity, the time to buy is now.
It is not possible to time the market but we know that valuations are low today and the returns will likely be very compelling over a multi-year time period.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.