Time to Invest in REITs?

|
 |  Includes: AVB, CPT, ESS
by: David Enke

Real Estate Investment Trusts are designed to give investors an opportunity to invest in real estate, which over the long-term has performed pretty well as an asset class, the last year notwithstanding. Last week (2/2 - 2/6) even saw a pretty nice move in the REIT market, below the returns of the Nasdaq (QQQQ) and S&P 500 (NYSEARCA:SPY), but slightly above the DJIA (NYSEARCA:DIA).

Source: Wall Street Journal


Of course, the days of easy credit, structured real estate products freeing up capital, and rampant building may be over, most likely taking with them above average returns. Nonetheless, there may still be some opportunities in REITs as the housing mess unfolds and sorts itself out, and the Treasury department finally starts addressing the housing issue (see WSJ article regarding a proposed loan modification program - details later). Note: Citigroup (NYSE:C) and JP Morgan (NYSE:JPM) have agreed to a foreclosure moratorium for 90 days (see WSJ article), in anticipation that additional details of the Treasury plan will be available within the next three months.

For those considering investments in REITs, it is important to remember that not all REITs are created equal, nor are they all the same, but instead come in many flavors. Reported data for REITs is also different. Instead of sales, REITs report rental income as revenue. An advantage for REITs is that much of this income is relatively consistent given that long-term leases are often in place. Obviously, when dealing with rental income, the higher the occupancy rate, and the easier the ability to raise rates, and the higher the reported revenue. While the ability to raise rates is probably not currently in the cards for most REITs, some may begin to see an increase in occupancy rates, or at least a level of stability not seen in all markets (more on this later).

Valuation of REITs is a little more difficult, or at least different, compared to traditional equity valuation. While Book Value per Share can be used, in active markets such ratios can produce extreme values. A common approach that is often used instead begins with using Funds from Operations per Share, which includes net income, along with depreciation and amortization, minus any gains or losses from any asset sales. It is worth noting that both depreciation and interest rise significantly with increased financing, with REITs often having debt-to-equity ratios above 50 percent.

Even with a valuation approach in hand, and data one can trust, it must be remembered that not all REITs are likely to benefit in each unique market. One strategy which individual investors are utilizing in the current market is to purchase unfinished homes, often at a steep discount after builders either choose, or were forced, to move on (see SeekingAlpha article). After investing a little more money to finish the home, such properties are being rented out. Even in poor real estate markets, such as Florida and California, the rental market is doing well, and offering such rental opportunities - after all, as the thinking goes, people need to live somewhere. While individual investors may not be able to make the same large investments, there are various REITs that invest in residential rental real estate. Some of those listed in the aforementioned article include CMG Realty (MUTF:CGMRX), Third Avenue Real Estate Value (MUTF:TAREX), Avalon Bay Communities (NYSE:AVB), Essex Property Trust (NYSE:ESS), and Camden Property Trust (NYSE:CPT), yet most of these REITs have their own issues and require additional due diligence.

To support the rental argument, the Real Estate Channel (see article) has recently stressed how "apartments continue to be the product of choice in national investment circles," while Apartment Investment & Management announced in its latest conference call that "the multi-family investment market continues to be relatively liquid." Yet, not everything is rosy, as others feel that Apartment REITs are susceptible to the downturn, no matter how they might be positioned to other REITs (see InvestmentNews article). Other REITs, like commercial REITs, may also not do as well, and are being recommended as good shorts, even at these depressed levels (see SeekingAlpha article). Like just about everything else in the market right now - enter at your own risk. Trying to catch a bottom, especially after a relief rally and a detail-free plan from Treasury, is always risky.