Last week, I told you I would soon have a couple of real estate-related bonds for you to consider.
I realize that recommending real estate-related securities right now is considered the most horrific suggestion in the history of horrific investment suggestions—after all, everyone “knows” that commercial real estate will collapse soon. The very best people say so. It’s in all the papers. The collapse is inevitable and imminent. Apartments will be empty as far as the eye can see. Offices will be turned into 25-story terrariums. No one is ever going back to work—only having to dress for business from the waist up, while wearing sweatpants and fuzzy slippers, is so much better than going downtown every day.
And with mortgage rates going up, no one is going to buy a house. Not only that, but malls are so 1970s. Everyone buys everything on Amazon (AMZN).
And so, real estate is going to collapse, and investors will be wiped out – is the story, at least.
I read the same headlines everyone else does. And the more I read them, the more excited I get about owning real estate-related debt.
Let me show you why…
There is a grain of truth in the headlines: there is a lot of commercial real estate-related debt maturing in 20203 and 2024. And yes, there will be some defaults.
Most of these will be central business district (CBD) office buildings in those cities in which working from home has dramatically decreased the demand for office space. But the vast majority of not-CBD office debt will be rolled over or restructured with no loss to creditors.
Multifamily demand and occupancy levels remain high. The housing affordability issue has been worsened by higher mortgage rates and increased demand for apartments. Multifamily vacancy rates are falling, even in those cities like Phoenix, a lot of new construction was completed in the last year. But even in cities like New York and San Francisco, where no one wants to go to the office, multifamily occupancy remains high.
While I, too, am a huge fan of Amazon, Class A malls, open-air retail, and outlet centers are still seeing a lot of activity. Sure, retail has been out of favor for a long time, and new construction has disappeared. But that means that for the most part, the centers that were going to fail have already done so. Today, the number of stores with new tenants currently outnumbers the number of new stores under construction.
Now, let’s talk about bond markets in general. We will see at least one more and possibly two more rate hikes in 2023. We are, however, much closer to the end of the rate hike cycle than the beginning.
This is bullish for bonds—especially bonds that were issued with low coupons, and have since seen revaluations downward as interest rates have risen. It is even more bullish for real estate-related bonds that have also seen some selling by people who love headlines but do not pay much attention to details.
The Tanger Properties (SKT) bonds due in September of 2031 are a prime example of a fantastic opportunity in real estate debt. The bonds were issued in 2021 with a coupon of 2.75%. As rates have risen, the bonds have fallen under $750 per $1000 par value and currently yields about 3.7% on a cash basis. The yield to maturity to reflect the recapture of the discount to par value is almost 7%. This is an investment-grade credit with a BBB- from Standard and Poors and Baa3 from Moodys. If and when rates come down, the price of this bond will move higher very quickly.
The office market is terrible right now—unless, that is, you are talking about offices in the Southeastern Sunbelt—and 95% of Highwoods Realty’s (HIW) offices are in the Sunbelt. Highwoods has an occupancy rate of almost 90% right now. (Nationally the occupancy rate is less than 82%.) Its tenants include stalwarts like Bank of America (BAC), The United States Government, Vanderbilt University, and Met Life (MET).
In 2020, Highwoods issued bonds with a 2.6% coupon due in February 2021. Today these bonds also trade for less than $750, giving them a yield to maturity of 6.9%. This is also considered investment grade by both major rating agencies. And the bond will also move higher if rates begin to come down.
Owning a portfolio of real estate-related debt makes sense right now. Even the best credits offer rates of return that are likely much better than the stock indexes can provide over the next decade.
