Real estate is a proven investment asset class that has created many millionaires over the years. Meanwhile, publicly traded Real Estate Investment Trusts (i.e., REITs) (VNQ) provide many investors access to and even accentuate the investment benefits of real estate without the prohibitive start-up costs and hassles.
That said, Warren Buffett and Charlie Munger - arguably the two greatest investors of all time - have never invested much of Berkshire's holdings in physical nor publicly traded real estate, leading some to question whether REIT investing is all that it is hyped up to be by many investors. In this article, we will look into why Warren Buffett and Charlie Munger do not invest much in REITs, but many other investors may still want to consider doing so.
The Benefits of REITs
First, let's look at why REITs are generally such a great business model:
Better Returns with Lower Risk: REITs have historically offered better returns with lower risk compared to rental properties. This superior performance stems from economies of scale, stronger bargaining power with tenants, the ability to develop assets, and access to better talent. For instance, renowned REITs like Realty Income (O), Public Storage (PSA), and American Tower (AMT) have compounded returns at an impressive 15% annually over the long run.
Liquidity and Diversification: Unlike physical properties that can take months to sell, REITs are publicly traded, offering immediate liquidity to investors with much lower frictional costs. Furthermore, they provide diversification as they invest in multiple properties across various sectors and regions, reducing the impact of a poor-performing asset.
Professional Management: REITs are managed by professionals with extensive industry knowledge. This ensures that the properties are well-maintained, tenancies are optimized, and the overall portfolio is strategically aligned with market trends.
Misconceptions about Leverage: A common misconception is that investors can't use leverage when buying REITs. However, REITs themselves are leveraged investments. When you invest in a REIT, you're essentially providing equity, similar to a down payment for a property. The REIT then leverages this equity by adding debt, allowing your investment to benefit from the advantages of leverage.
Tax Efficiency: REITs distribute a significant portion of their income to shareholders via a distribution that often enjoys tax advantages. First and foremost, REITs do not have to pay corporate income tax as a "pass through entity" and also generally speaking 20% of the taxable portion of the dividend is written off as tax-exempt. Furthermore, a part of a REIT's dividend payment is often classified as "return of capital," which is tax-deferred due to accounting depreciation of the underlying real estate. Moreover, REITs typically reinvest a portion of their cash flow, which is also tax-deferred, enabling investors to compound that capital over the long term at higher rates than they would otherwise.
Growth and Appreciation: REITs often invest in premium properties and have access to public capital markets, enabling them to raise additional capital for growth. This positions them for greater long-term appreciation compared to individual rental properties.
Market Agility: With REITs, investors can easily enter or exit the market based on their assessment of market conditions. In contrast, rental property owners might find it challenging to sell their properties quickly, especially in a downturn.
Why Warren Buffett And Charlie Munger Don't Like REITs
If REITs are so great, why haven't Warren Buffett and Charlie Munger bought them hand-over-fist?
First and foremost Berkshire Hathaway (BRK.A) (BRK.B) has made a few investments in REITs over the years, including a holding in STORE Capital (STOR) (which was since taken private by a group that included Blue Owl Capital (OWL)) as well as Seritage Growth Properties (SRG). That said, given their vast business empire, Buffett and Munger have invested relatively very little in real estate over the years, while investing aggressively in stocks like Apple (AAPL), IBM (IBM), Coca-Cola (KO), Wells Fargo (WFC), and American Express (AXP).
What explains this phenomenon? Looking at their past quotes, here are some likely reasons:
Lack Of A Competitive Edge: Warren Buffett and Charlie Munger are keenly focused on investing in places where they believe they have a competitive advantage over other investors. Real estate is a highly competitive industry with many participants. As a result, real estate is rarely inefficiently priced, making it hard to make truly good buys. As Charlie Munger put it:
“We don’t have any competitive advantage over experienced real estate investors in the field."
Buffett himself said something similar and extended this to REITs:
I think [real estate] tends to be more accurately priced, particularly more developed real estate, most of the time...under most conditions it’s hard to find real estate that’s mispriced...when I look at the transactions REITs engage in currently, and you get a lot of information on that sort of thing, they’re very similar and it’s a competitive world, and you know, they all know what a class A office building, you know, in Chicago or wherever it may be, is going to produce. They at least, may all be wrong because of some unusual events, but it’s hard to argue with the current conventional wisdom most of the time in the real estate world.
While these arguments make some sense, they ignore the simple fact that REITs - like all stocks - often experience significant volatility in the public markets that far outpaces what is experienced in the private markets. As a result of this frequent public-private market valuation disconnect, while the underlying real estate of a REIT may be seldom mispriced, the stock prices of REITs most likely are at least some of the times. Wouldn't Warren Buffett and Charlie Munger want to capitalize on that? This brings us to the second big reason why Buffett and Munger do not buy REITs...
Tax Inefficiency: Berkshire Hathaway is a taxable C-Corporation, and therefore has to pay a layer of corporate taxes on any real estate income it receives and the use of the income by the people who directly own the real estate. This offsets much of the tax benefit of investing in REITs in the first place. As Charlie Munger explains:
if you operate as a corporation such as ours, which is taxable under chapter C of the Internal Revenue Code, you’ve got a whole layer of corporate taxes between the real estate income and the use of the income by the people who own the real estate. So, by its nature, real estate tends to be a lousy investment for us.
Poor Rates Of Compounding: Another big reason why REITs generally have low appeal to Buffett and Munger is because real estate generates poor returns on invested capital. As Buffett once said:
The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.
Real estate - largely due to its perceived safety - is quite easy to leverage. Given how low interest rates have been for so long, the cap rate (effectively the yield on invested capital) in most real estate categories is in the single digits given the extensive leveraged demand that has been put on the sector. Since investors often purchase real estate assets with fairly cheap leverage, they are perfectly content with purchasing a property at a mid-single-digit cap rate since their return on equity can then be boosted into double-digits.
The difference for Buffett and Munger is that they do not make buy-sell decisions based off of leveraged return projections but instead on unleveraged returns. As a result, most real estate investments - even when REITs are somewhat discounted in the public markets - still do not offer an implied cap rate in the double digits, which is typically what they look for in their investments. Moreover, Buffett and Munger are looking for businesses where they can hold them for a long period of time and reinvest in those businesses at high rates of return on invested capital. Few to no REITs pass that test.
Investor Takeaway
Buffett and Munger do not buy real estate because:
1. They feel they lack any real edge in the sector.
2. They are tax-inefficient investments for their corporate structure.
3. The returns on invested capital are typically too low for their long-term, buy-and-hold compounding approach to investing.
That being said, REITs could still make a lot of sense for small retail investors, especially right now. Given the massive discounts to NAV being seen in the sector - even among blue chip REITs like Realty Income, Crown Castle (CCI), and Simon Property Group (SPG) - the implied cap rates on purchases are in the high single digits which provide a pretty attractive return on invested capital right off the bat.
Moreover, REITs are much more tax-efficient for individual investors, who may get the 20% write-off on any taxable REIT dividends given that they are considered to be "pass-through" entities by the IRS (this is not tax advice; please consult a tax expert to confirm this). Additionally, individual investors can always hold REITs in a tax-advantaged account like an IRA or 401k.
Finally, while it is true that virtually all REITs have fairly low returns on invested capital, for those who have much smaller account sizes, taking a more active approach to portfolio management can make a lot of sense. While Berkshire Hathaway's massive portfolio size requires that they limit their market activity due to the difficulty of entering and exiting large positions quickly, small investors can do this with ease. As a result, you do not need to buy and hold REITs for many years. Instead, you can buy when REITs trade at steep discounts to NAV and then sell when that gap to NAV closes meaningfully, rinsing and repeating as the market gives you the opportunity.
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