Real estate companies hit the skids last year, but that slump set them up for gains ahead, says Jeffrey Kolitch, manager of Baron Real Estate Fund (BREFX).
The fund placed in the first percentile of real estate mutual funds for the five- and 10-year periods ended Feb. 28, according to Morningstar.
The annualized return was 9.35% for five years and 9.38% for 10 years.
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Unlike in past economic downturns, leverage and overbuilding aren’t big problems in the real estate sector now, Kolitch says. Debt is limited, commercial and residential real estate isn’t overbuilt, and construction forecasts aren’t high.
Among the sectors Kolitch likes are industrial real estate investment trusts, travel-related real estate companies and residential real estate companies.
Here are his thoughts, including stock picks.
TheStreet.com: What’s your investment philosophy?
Kolitch: We look for real estate companies that own unique, well located assets in markets with attractive long-term growth prospects. It’s companies that have conservative balance sheets and excellent management.
We evaluate real estate through a wider lens than most of our peers. We invest in REITs and non-REITs. About 95% of our competition is limited to just REITs.
TheStreet.com: What’s your outlook for the real estate sector in general over the next year?
We are cognizant of the reasons to be cautious. But despite the volatility, we believe the setup for real estate in the public market is attractive.
Public real estate valuations have corrected sharply over the last year, with share prices down 20% to 60%. That sets up the next two to three years for compelling real estate profits. Public real estate rebounds sharply after economic dislocations.
We’re identifying value in a number of categories. The current real estate environment is far superior than past cycles. In the past, trouble has surfaced following excess leverage and overbuilding.
But this time, the use of debt has been limited compared to history. Commercial and residential real estate aren’t overbuilt, and expectations for construction activity are modest.
This is as optimistic as we have been for real estate heading into an economic downturn. Any correction for real estate is unlikely to be steep. Public real estate is on sale.
Jeff Kolitch
TheStreet.com: What sectors of the real estate market are most attractive now?
Kolitch: We have four themes. First, as I alluded to above, the sharp correction of 2022 set up several REITs for an attractive two to three years.
Business prospects are solid in most categories. Balance sheets are in good shape, yields are well covered by cash flow and often growing. This includes secular growth REITs – industrial/logistics, data center and life science.
There are also REITs with short-lease durations, giving them pricing power. Self-storage properties have 30-day leases. And single-family homes and apartments are one year.
One example of this theme is Rexford Industrial Realty (REXR). It has the best long-term growth prospects among all public REITs. Its properties are in Southern California, the strongest industrial market in the country.
They have assembled an owned portfolio of industrial real estate [that can't be replicated]. They have rents that are 65% below market. So they can have 65% growth just by increasing rents when leases expire. They are highly acquisitive. Over time, we believe management will double their holdings from 44 million square feet now.
TheStreet.com: What’s your second theme?
Kolitch: Travel-related real estate. There has been a secular shift in favor of long-term prospects for travel real estate, including hotels, casinos and time shares. There’s a priority for spending on services like travel instead of goods. An increasing wallet share is going to travel.
MGM Resorts International (MGM) is a beneficiary. Two-thirds of its cash flow comes from the Las Vegas Strip. And we’re bullish on Las Vegas. It’s becoming more year-round with events, and business and international travel look good in the near term.
The management team is doing a great job on the balance sheet and capital allocation. The stock is worth in the high $50s to $60 based on the sum of its parts. [It recently traded at $43.]
TheStreet.com: What’s your third theme?
Kolitch: Residential real estate companies. We’re bullish long-term on the housing market, despite the [short-term] headwind of high mortgage rates.
Long term there’s underconstruction compared to demographic needs, given household formation. That bodes well for housing construction, home rentals, home repair.
One beneficiary is Toll Brothers (TOL), the country’s leading luxury-home builder. They have a highly capable management team that has acquired and developed a large and valuable land portfolio in markets with strong demographics.
Toll Brothers is a bit isolated from high mortgage rates because 20% to 25% of its buyers pay in cash. It has a pristine balance sheet and the stock is cheap. It trades at a slight discount to estimated 2023 book value. The long-term average is a 1.4 to 1.5 premium.
TheStreet.com: What’s your final theme?
Kolitch: Call it “other.” We are long-term bullish on real estate service companies CBRE (CBRE) and Jones Lang LaSalle (JLL). They have a duopoly, and there are opportunities for consolidation.
We like alternative real estate managers Brookfield (BAM) and Blackstone (BX). And we like real estate data analytics companies, such as CoStar (CSGP).
