Cohen carefully danced around the subject of the massive bubble in large cap equity REITs. The bubble is nicely captured by the iShares Cohen & Steers Realty Majors ETF (ICF).
This nifty chart shows the staggering market performance of index of the top 30 equity REITs:
The Realty Majors ETF is currently yielding 3.14%, which is noticeably less than the current T-bill rate of 5%. To justify such a high valuation, the index REITS must register FFO (Funds From Operation) growth in the 10% range in 2006 and beyond. This is much higher than the historical CPI+1-2% FFO growth rate of stable equity REITs.
REITs have generally traded at a 150-300 basis point spread over the treasury yield. The positive spread was compensation for the higher risk of real estate cash-flows. By nature REITs have exposure to tenant credit risk, as well as external economic risks of the varying demand for retail and office space. Even taking into account the positive benefits of internal portfolio diversification, equity REITs cannot be safer than treasury bills or online savings accounts. New investors have a negative margin of safety.
Astute REIT managements use their own overvalued shares as currency to acquire slightly less overvalued REITs.
Recent M&A (merger and acquisition) mania in REITspace is driven by very cheap capital. This cheap capital comes from two sources. There is exogenous capital from private equity buyers fortified with cheap loans. And there is endogenous capital, from stock swaps, as astute REIT managements use their own overvalued shares as currency to acquire slightly less overvalued REITs. The recent proposed takeover of Glenborough Realty (GLB) by a syndicate led by Morgan Stanley (MS) is an example of exogenous capital. The silly takeover of Reckson Associates Realty (RA) by SL Green Realty Corp. (SLG) through an all-stock deal is a fine example of internal trading of paper for paper.
Probably the best description of what is happening and has happened in REITspace comes from Richard DeKaser, Chief Economist at National City Corp.'s (NCC) Economic Office. Paraphrasing from the June 2006 Financial Market Outlook, talking about the residential housing market:
Under ordinary conditions, which are implicitly embedded in most statistical models, rising prices subdue demand, all else being equal. But in a bubble the opposite is true; rising prices not only fail to subdue demand, they actually excite it. [REIT Investors] make purchases not based on relative value propositions (e.g. [relative asset returns]) but on the belief that future price gains will reward current purchases. This self-fulfilling proposition then builds on itself. That is, until it doesn’t, and the economics profession isn’t especially strong at pinpointing these tipping points.