2 Real Estate Development Stocks to Consider

By: , Contributor

Published on: Aug 31, 2019 | Updated on: Oct 03, 2019

Office buildings can be great investments -- but owning an office building isn't right for everyone. Here are other options that will appeal to investors.

There are several ways real estate investment trusts, or REITs, can create value for their shareholders.

The most obvious is through rental income. But REITs can also make money by selling properties at a profit or managing properties they don't own. One of the least-understood ways REITs can build shareholder value is by developing new properties. It may not be well understood, but it can be very lucrative.

One of the least-understood ways REITs can build shareholder value is by developing new properties. It may not be well understood, but it can be very lucrative.

Not all REITs develop real estate, so let's look at why development-focused REITs can be so valuable for investors. Then I'll share two REITs that invest a lot of money in development for you to consider.

Why real estate development can be such a great source of value

Real estate development can help a REIT supercharge investors' long-term returns if it's done right. If a REIT builds a property for less than it would cost to acquire a comparable property, it creates immediate equity for investors.

Here's a simplified example. Let's say that apartment buildings are selling for a 6% cap rate. A building that generates $60,000 in annual net income could be expected to sell for $1 million.

Let's also say you could construct an apartment building that generates $60,000 in annual net income for a total cost of just $800,000. Not only are you getting a superior 7.5% annualized yield on your construction cost, but you also create $200,000 in immediate equity for your investors. After all, you could theoretically turn around and sell the completed building for $1 million.

If a REIT does this over and over, it can translate to tremendous long-term value creation for investors.

Two real estate development stocks to consider

With that in mind, here are two REITs that allocate a large part of their investment dollars to developing properties from the ground up:

Company (Symbol) Property Type Current Development Pipeline
AvalonBay Communities (NYSE: AVB) Apartment communities $2.4 billion
HCP, Inc. (NYSE: HCP) Healthcare $1.3 billion

Data source: Company presentations, Q2 2019.

AvalonBay Communities

AvalonBay Communities is an apartment REIT that focuses on high-cost urban and suburban markets. For example, New York and San Francisco are both among AvalonBay's core markets. AVB recently expanded its efforts to the Denver and South Florida real estate markets, too.

The company currently has 291 apartment communities in a total of 20 U.S. markets and has $2.4 billion worth of new properties under construction. And to illustrate the power of ground-up development, AvalonBay estimates that these properties will be worth $3.2 billion upon stabilization -- a value creation of $800 million.

AvalonBay Communities' business model is a time-tested growth machine. Since the company's 1993 IPO, it has generated a 13.3% annualized total return for investors and has increased its dividend at a 5.2% annualized rate in that time. To put this into perspective, this means a $10,000 investment in AvalonBay's IPO would be worth about $257,000 today (assuming dividend reinvestment) and would be generating $7,500 in annual dividend income.

HCP

HCP is one of the largest healthcare-focused REITs in the market and owns three types of properties -- senior housing, medical office, and life science. Each makes up a roughly equal portion of the portfolio. As of the latest available information, HCP has 734 properties.

The company has been publicly traded for 34 years and pays a generous 4.3% dividend yield based on its share price as of late August 2019.

HCP currently has a $1.3 billion development pipeline, and the properties it has under construction are more than 60% pre-leased. The company estimates that upon stabilization, the assets currently under development will have a market value between $1.8 billion and $2 billion. That's $500–$700 million in value creation from its current development activity. What's more, HCP says that it has a "shadow" pipeline of more than $700 million in additional future development opportunities based on undeveloped land it has.

Development is a long-term wealth creation strategy

As a final point, it's important to emphasize that real estate development is a long-term investment strategy. The development projects currently underway from the two REITs I've discussed here will take several years from the start of construction to stabilization, and there are simply too many factors that can move a REIT's stock price in the short term.

For that reason, I wouldn't suggest investing in these (or any other) REITs with money you might need within the next five years. Longer investment time horizons are even better for this type of stock. However, as both of these stocks have handily beaten the S&P 500 over the past 25 years, it's clear that development-heavy REITs can be a great way to achieve excellent long-term results.

Matthew Frankel, CFP has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.