Are REITs Undervalued?

| About: Vanguard REIT (VNQ)

I don't think so. I recently read SA contributor Brad Thomas's article about REIT valuations, and I believe that REIT funds such as the Vanguard REIT ETF (NYSEARCA:VNQ) are not poised for outperformance. In the article, he argues that the conventional wisdom about REITs underperforming in a rising interest rate environment is incorrect. I agree with him. There does not seem to be a strong relationship between REIT performance and interest rates. However, I still do not think that now is the time for total return investors to over-weight REITs in their portfolios.

Sector Cyclicality vs. REIT Exceptionalism

Before I continue my analysis, let me first state my theory of relative sector valuations. I believe in a very, very weak form of the efficient market hypothesis. While individual sectors may outperform over long periods, I do not think that outperformance is structural. If a sector begins to have a long winning streak, investors will overweight that sector in the hope of outperformance. Such increased enthusiasm will lead to investors overvaluing the sector and funding marginal business that would never have gotten off the ground if the sector were not fashionable. As examples, consider energy companies at the oil price peak in the late 1970s, internet companies in the late 1990s, and financial companies in the 2000s. In fact, it is precisely when a sector is unfashionable and investors are stingy that companies must maintain discipline and show excellent results in order to attract any attention. In my opinion, the cyclicality of sector performance is an inevitable part of the market.

Mr. Thomas and others on SA have made the case for REIT exceptionalism, pointing towards special tax breaks and dependence on capital markets relative to other sectors because REITs must pass-through at least 90% of their profits to shareholders. Personally, I'm skeptical of this argument. While lower taxes will increase returns to investors, REITs are not unique. Tech is famous for its ability to pay much lower effective taxes. Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG) are notable examples. I'm also not convinced that the inability to retain earnings leads to more rational capital allocation. REITs are in a business that is highly prone to boom-and-bust cycles, as anyone living in California in the 1980s or anyone in the world in the 2000s will attest. Moreover, depending upon the capital markets for financing, it can be a double-edged sword. It reduces slack, which can improve discipline but also reduce flexibility and make companies more vulnerable to market turmoil. So while REIT fans do make cogent arguments about why REITs are structurally superior, I'm on the sector cyclicality side of the debate.

A History of REIT performance

So what makes REITs fashionable? The answer is relatively easy: real estate booms and/or general skepticism of equities. Below is a figure of the total return of the Wilshire REIT index divided by the total return of the Wilshire 5000 total market index. When the line is going upwards, REITs are outperforming the market, and when the line is going downwards, REITs are underperforming. Both indices are normalized to 100 in 1980. This means that if the line is above 1 after 1980, REITs have cumulatively outperformed, and if the line is blow 1, REITs have cumulatively underperformed.

From the late 1970s until about 1985, REITs handily outperformed the overall market. This makes sense, because during this period investors were skeptical about investing in equities after a long period of negative real performance. Unlike most other sectors, REITs can double as an "alternative" asset class, so investors piled into the sector. After the overall market had a few years of good performance, investors began their long love affair with equities, causing REITs to underperform for a decade and a half (with the immediate post-1987 cash period as a brief exception). By the late 1990s, REITs had become so unpopular with investors that there were only a few lonely cheerleaders for the sector. Few fund companies offered retail products specifically devoted to REITs, and the idea that a know-nothing index investor would overweight REITs was unheard of.

Fast forward to the 2000s. The collapse of the tech bubble burned many investors, who became increasingly skeptical of equities in general. An industry of "alternative investments" flourished, from commodities to hedge funds to real estate. This was good news for those patient holders of REITs. The sector outperformed the overall market by so much from 2000 to 2008 that REITs cumulatively outperformed the overall market since 1980.

Not surprisingly, after the collapse of the housing bubble, REIT investors dumped their holdings en masse. This caused REITs to underperform the market in 2008 and 2009. However, a variety of factors contributed to the resurgence of REITs after the current bull market picked up speed. First, interest rates were low, and REITs seemed like a good source of income. Second, investors had been burned twice in a decade by equities and frantically searched for any strategy to mitigate or diversify risk. Third, REITs had dramatically outperformed the overall market since 2000, so they seemed like a good bet going forward.

"Everybody Needs REITs"

Fund companies met this growing demand with a bewildering array of investment products devoted towards real estate. In my opinion, the transition from conventional wisdom with logical support to uncritical acceptance was the development of the Vanguard Global ex-U.S. Real Estate ETF (NASDAQ:VNQI) in 2010. What's not to like in a product like that? There's global diversification, and real estate is a winner in the long run, right?

REIT purists that focus on domestic companies will point out that VNQI is not the same thing at all. But that is exactly my point: real estate-related investment products have become an integral part of many investors' strategies. Given that REITs are not a large portion of the overall U.S. market cap, this strategy does not need to become too popular to distort REIT valuations.

Current Underperformance

This argument may sound like old news to many readers. After all, REITs have collapsed in the last several months while the market zoomed upwards. The figure above shows that REIT outperformance since 1980 has totally disappeared. REIT bulls such as Mr. Thomas propose that investors buy the dip. From a sector cyclicality perspective, however, the case for REITs is less clear. When investors have turned their backs on REITs in the past, they have been very poor performers indeed, sometimes for decades. Additionally, in prior periods of underperformance, the shake-out is much more severe than has happened so far this year. As long as there is a "buy the dip" mentality among the marginal REIT investor I don't think that REITs have reached a relative cyclical bottom.

So who is that marginal investor? In my opinion, it is the investor that is trying to decide whether to hold a REIT investment product as a part of a diversified equity portfolio. Rather than focusing on individual security analysis, these investors are trying to decide whether they like a particular "investment theme." Such investors are often retail or pension funds, who can be slow to change their mental investing maps. This is especially the case when asset classes underperform in relative terms but still provide positive returns. In such cases, the investor can slowly retreat from the outperformance justification to the diversification justification before finally giving up on the asset class altogether. I could be mistaken, but my sense is that while the "REITs as outperformers" argument is getting less credence, "REITs as diversifiers" is still alive and well. After all, we still have a long way to go from current investor sentiment regarding equity risk to 1990s-era enthusiasm that marked a cyclical valuation bottom for REITs. Investors are increasingly long the market, but the decade-long bull market in hedges and "uncorrelated" assets continues. As a result, capitulation could still be years away.

Limitations and Implications

There are several limitations to my argument. I cannot speak to the valuation of a particular REIT, so there may be good individual companies in the sector. Also, investors looking for current income rather than total return may prefer REITs because they offer higher dividends than the overall market. But I do not believe that a strategy of tilting towards or over-weighting REITs looks especially promising in the coming decade for total return investors. I will get more interested after the sector has underperformed for a longer period of time and has lost its cache among investors. This is especially the case if sentiment about equities continues to improve in the next few years while REITs are cast aside. When REITs are no longer a common investment theme but instead an investment backwater, I'll buy.

Disclosure: I am long VTI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.