REITs: High Valuation, Questionable Value

Barron's recently published an interview with Marty Cohen of Cohen & Steers (CNS), an asset manager that specializes in REITs and Utilities. The subject of the interview was REITs.

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:

Negative Margin

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.

Comments

[FIG trader]

Almost 3 months later, and the REITs are even more overvalued according to "market participant". He may be correct, but he hasn't outlined probabilistic scenarios assessing the security of the revenue stream (i.e. recession, rent and lease cuts) or how it is to be discounted (i.e. interest rates). I'll put in my two cents, though I still think it is 50/50 whether it actually happens. There is some momentum money here, but lots of foreign investors (Need I say stodgy Germans) who have been buying real estate for some time. The possible trigger seems to be a run on the dollar, which could spank the Treasury markets, though at this precise moment the exact opposite is happening. Treasuries are being bid, and $ is being sold down the river. Do we break $1.35/ Euro? I think more profound reasoning is needed to make a real bear case. There is one smart investor who bought homebuilders cheap and sold them when they were expensive. As of few months ago, he was still massively long apartment REITs. His name is Heebner and he runs CGM realty. I would look for what he has to say to get the skinny on what ti look for in a top of this market

[DavidJackson]

(1) Is there anything by Heebner available online?
(2) I also noticed the bizarre reaction of Treasuries to the falling dollar. You would have thought that a falling dollar would increase inflationary pressure and thus the need to raise rates; or an alternative mechanism, complaints from trading partners about the weak dollar and thus demands to raise rates to keep it strong. Whichever mechanism it is, you'd expect the upward pressure on rates to pressure Treasuries. But they've been v. strong.

[FIG trader]

not sure; you can probably check holdings of funds, and than any potential chnages in Q3 filings, though think they can hide it if they really want to. CNBC may have transcripts from his recent interviews