Real Estate Stock Selloff Is a ‘Gift’ to Investors, This Pro Says

Kolitch has managed the fund since its 2009 inception, but his interest in real estate stretches back decades. “My father, who is my closest mentor and adviser, has been a private real estate developer and landlord for most of his professional career,” says Kolitch.

The fund manager recalls being a teenager visiting a shopping center his father had developed, when he asked his father to explain what he did for a living. The answer—which touched upon the concepts of anchor stores, rent payments, and land appreciation—“sparked a curiosity” that led to a college major and, ultimately, a career.

Kolitch spoke with Barron’s on June 20 about how investor jitters are creating attractive opportunities for real estate investors. An edited version of the conversation follows.

Barron’s: In your latest quarterly letter, you highlighted a number of real estate-related companies that you consider attractively valued. Why now, when so many investors are down on the sector?

Jeffrey Kolitch: There is a fair amount of caution and concern regarding real estate investments because of the narrative out there: We could be on the cusp of a commercial real estate crisis, there are challenges in the housing market, and so forth. We disagree emphatically. The setup for real estate in the public markets is attractive.

For the past three and a half years, real estate–related stocks have faced a trifecta of headwinds. It started with the Covid pandemic, during which many real estate businesses were effectively shut down, which hurt the stocks. Then, real estate has been in the crosshairs of the most aggressive interest-rate tightening cycle in decades. Third, there are sensationalized—in our view—reports of a commercial real estate crisis on the horizon. As a result, many real estate stocks have lagged behind the broader market.

As we evaluate a larger swath of public real estate companies, two- to three-year return prospects look quite compelling.

Let’s take a closer look at the case for office real estate, which has been plagued by vacancy concerns as more people work from home.

There is an assumption that the challenges facing lower-quality buildings are representative of all of commercial real estate. We couldn’t disagree more. Most commercial real estate, and certain individual office buildings, are performing quite well. Yes, old and poorly located B and C office buildings are in both secular decline and perhaps what will be cyclical decline over the next couple of years. The new world, in which many employers are adopting more flexible work arrangements, will create demand pressures for occupancy and rent [issues] for lower-quality office buildings in the next few years.

When you layer on that the fact that in many cities there is an excess supply of older buildings, you have an unfavorable relationship between demand and supply. But what I am describing is a small percentage of the overall real estate landscape.

How does the rest of the market look?

At Baron, we believe that a commercial real estate crisis is highly unlikely. Very simply, business prospects for most commercial real estate operators are solid. There is little competitive new construction activity in the pipeline, as land costs, labor costs, and material costs have gone up. Debt profiles, generally speaking, are in pretty good shape.

After the failure of Silicon Valley Bank, there was concern about a major banking crisis. Sure, there perhaps will be additional challenges in the months ahead, but so far, it has been fairly contained. The loan defaults that you may read about will be largely isolated in the lower-quality B and C office space. This is an important point of clarification that is largely misrepresented.

We’re leaning into this dislocation because we expect it to reward our investors in the next few years. We continue to emphasize four high-conviction investment themes: real estate investment trusts, non-REIT residential real estate, travel-related real estate, and the commercial real estate service firms and real estate alternative managers.

What is the outlook for residential real estate?

Sentiment has picked up quite a bit. May housing-start and permit data were encouraging. We are long-term bullish on the prospects for the U.S. housing market. There has been a multidecade structural underinvestment in U.S. housing.

Six months into 2023, we’re seeing a meaningful uptick in demand in the housing market. Buyers are getting over the sticker shock that occurred last year, when mortgage rates went from a low of 3% up to 7% following a period of home-price appreciation of 30% to 40%.

There are several years of pent-up demand. Perhaps buyers are adjusting by purchasing a smaller home or choosing a different suburb, but this near-term dynamic has been one of the key pillars supporting the economy this year, and we think it will do so in the years ahead.

Which REITs look best to you now?

While certain REIT segments might face headwinds in the next few years, the setup for REITs in general is attractive over two to three years. Early in 2022, before the Federal Reserve’s tightening cycle, REITs were trading for 25 times earnings. Now they are 17 times earnings.

We are focused on what we would call secular REITs, whose cash flows are less vulnerable to an economic slowdown. Think about industrial REITs such as

Prologis

[PLD] or

Rexford Industrial Realty

[REXR], which are benefiting from the e-commerce trend and supply reconfigurations. Data-center REITs such as

Equinix

[EQIX] and

Digital Realty Trust

[DLR] are benefiting from cloud adoption, an increase in internet use, and perhaps artificial intelligence.

Short lease-duration real estate, whose leases are shorter in nature, may have an opportunity to increase rents on a more frequent basis to offset some of the inflationary pressures. Think single-family rental REITs such as

Invitation Homes

[INVH] and

American Homes 4 Rent

[AMH]; apartment REITs such as

AvalonBay Communities

[AVB] and

Equity Residential

[EQR]; or perhaps self-storage REITs such as

Public Storage

[PSA],

Extra Space Storage

[EXR], and

CubeSmart

[CUBE].

One of the non-REIT companies highlighted in your letter to income-fund shareholders,

[TOL], is closely tied to the residential market. Why do you recommend it, and how do you view its valuation and stock fundamentals?

Toll Brothers is a best-in-class home-building company. It is led by a highly capable management team. Over the years, it has acquired and developed a valuable owned-land real estate portfolio in excellent markets. Much of it was purchased before the run-up in home prices during Covid, so there is very little risk to the book value.

Importantly, Toll focuses on luxury homes. Toll Brothers is more insulated from higher mortgage rates because about 25% of the buyers of Toll homes pay 100% in cash. The company has maintained a terrific balance sheet. There are approximately 132 million households in the U.S., of which about 25 million earn at least $150,000 a year annually. That’s Toll’s target audience.

There is a massive addressable market for Toll. With its pristine balance sheet, several billion dollars of liquidity, and superior capital sources, the company has a major opportunity to increase market share at the expense of its competitors over the next several years.

Toll has been a good stock this year. It is trading at just over our estimate of 2024 tangible book value. The stock historically has been valued at 1.4 to 1.5 times book value, and had a peak valuation of two times book value. If the company can just recover to its long-term average, we would have another 50% upside.

What other opportunities do you see in commercial real estate?

Shares of the largest commercial real estate service firm in the world,

CBRE Group

[CBRE], have been pressured because the company got swept into the negative narrative. That has created a terrific opportunity to once again acquire a premier commercial company at a highly discounted price.

We are long-term bullish on the commercial real estate service industry. More companies…