Last September we put out our first note on the REIT sector with a focus on Vanguard's REIT Index ETF (NYSEARCA:VNQ). At that time the ETF was recovering from the initial market shock towards the Federal Reserve's initial communication strategy regarding how it would taper its ongoing Large Scale Asset Purchase Program (LSAP), known colloquially as QE3.
At that time it seemed reasonable that based on an estimated ~3.3% dividend yield of our sample REIT group (through Q2 data) which reflected a positive ~0.6% spread to the 10-year treasury -- that a price range of $63-$64 was fair for VNQ (a slight discount to its price at the time of ~$68). However based on the proximity of the 200-day moving average to VNQ's price, the REIT ETF would be volatile near-term between these price areas.
Four months later and the ETF remains in this range. The Vanguard REIT ETF closed at January month end at $67.32, just above its intermediate 10-month trend (using adjusted prices) of $66.84. The 200 day price average at the end of January was ~$67.19. Over the past four months, VNQ has traded between $63.50 and $71.05.
With prices having stabilized and growth in dividends more than offsetting the rise in treasury rates, the REIT ETF remains a fair value in the mid-$60s. Our expanded sample group of 30 REITS (price weighted) is trading at a ~3.40% dividend yield (slightly lower than our estimate of the underlying MSCI US REIT index of ~3.69%), which is an improvement over the sample group's Q1 yield of 3.03%. [The trailing dividend yield on VNQ is ~4.10% which likely reflects index activity and possible additional return of capital not reflected in a bottoms-up analysis]. 7%-8% dividend growth should support valuations moving forward. However, based on the potential bottoming of long-term treasury rates as well as the maturity of the current economic expansion - we continue to expect share price appreciation to slow towards the underlying dividend growth rate.
After the review of the REIT group trends, we have included an initial valuation analysis for use in reviewing individual REITS. Simon Property Group (NYSE:SPG), the largest publicly traded REIT is our test subject. We eschew Net Asset Value (NAV) methods for more traditional firm level valuation tools (i.e. Price-to-Book) that separate asset values and profitability. Actual asset values provide some stability to gauge current cycle profit levels that might be missed when focusing only on recent funds from operations (FFO) or net operating income (NOI). Our idea is to provide an alternative to NAV that builds additional granularity to answer questions regarding a firm's premium/discount to the underlying capital of the firm and a tool to gauge the relative attractiveness of individual REITS.
Intermediate Price Trend
We typically have published trend figures on a price adjusted basis, which is a proxy for total return. However, to better reflect the group index presented in our analysis, the following price series is not adjusted for cash flows received. Note that the smoothed 10-Month Moving Average (10MMA) has recently slowed and currently reflects a near-term plateau at ~$69 (October 2013).
Based on the underlying slow economic expansion and dividend growth, we would expect this to be a pause rather than an indication of an immediate decline. Saying that, having been below trend for several months is not often a positive.
Figure 1: Vanguard REIT ETF Monthly Closing Prices
Dividend Price History
The following analysis uses a subset of companies that make up the Vanguard REIT index (currently estimated at 65% representation geared towards large cap REITS). Some companies have been excluded to provide a cleaner operating history, which unfortunately adds survivorship bias. For instance General Growth Partners (NYSE:GGP) has been excluded given its bankruptcy in 2009. From our initial note, we also expanded the data by increasing the group to 30 and adding 2 additional years. This will through off comparability slightly from our previous write-up.
Figure 2: Trailing Twelve Months Dividends and Price History (through Q3'13)
Source: Author Calculations
The sample group index almost captured its Q1'07 peak in Q1'13 before pulling back. The dividend yield at ~3.0% has remained a ceiling to prices over the analysis period. Supporting the REIT group has been strong dividend growth which has not showed signs of slowing yet. September y-o-y growth was 8.3% and December growth is an estimated 9.1%, which would mark the current cycle high. The last 8 quarters of growth has averaged 7.9%.
Figure 3: Year-over-Year Dividend Growth
Source: Author Calculations
While dividend growth is largely based on economic fundamentals related to each firm's real estate portfolio and investments - there has been a sector tail wind supporting firm valuations. This is due to lower interest rates which impact all asset classes including equities. Figure 4 shows the group's dividend yield history relative to the 10-year treasury.
Interesting that some analysis recently provided to support REIT valuations in a rising interest rate environment isolated the 2004-2006 time period where REIT yields were lower than treasury yields. Unfortunately that analysis ignores what happened from 2007-2009! While one should not subscribe to a direct correlation between treasuries and REITS - clearly the dividend yield has tracked the 10-year treasury rates lower over time. The current spread is a positive ~0.8% over the 10-year treasury, which is the long-term average as presented.
Figure 4: Dividend Yield History
A quick note on the various yields we are using. Our yield estimate at ~3.40% is lower than the index given its focus on the larger REITS in the index. Our estimate of the underlying 131 REITS in the MSCI US REIT index is higher at 3.69% (weighted according to the index as reported by Vanguard). The actual MSCI US REIT index is higher at ~4.1% in-line with the VNQ reported dividend yield. We are assuming at this point that index activity is driving the higher yields and could be reflected in a higher proportion tied to return of capital. (Further analysis is required.)
VNQ is also believed to have the highest dividend yield compared to other similar ETFs. iShares US Real Estate ETF (NYSEARCA:IYR) has an estimated current yield of 3.8% but includes a modest allocation to higher yielding mortgage REITS offset by a higher fund expense ratio of 0.45% (compared to VNQ's 0.10% expense ratio). State Street's Dow Jones REIT ETF (NYSEARCA:RWR) currently yields 3.3% (the underlying index is 3.79%). RWR has a 0.25% expense ratio.
Asset Values versus NAV
In the review of the REIT sector, we have focused mainly on broad trends. When drilling down to specific REITs, there is clearly a sector-specific way of valuing these unique firms. However, capitalizing the firm's net operating profits to generate a net asset value is not as attractive in this author's opinion. Rather, comparing profitability against the firm's actual assets seems a bit closer to value investing and Price-to-Book metrics. While this pits stated book value against the more appropriate current market value - it should still provide a useful measuring stick. Thus, we are leveraging the concept of invested capital (IC), which is the total assets of the firm net of non-interest bearing current liabilities (TA - NIBCLS), for a capital base. To measure the profitability of this base we are using return on invested capital (ROIC), which is the net operating profits after tax (NOPAT) divided by the firm's invested capital (NOPAT/IC)
We compare the firm's invested capital with the market's valuation of the REIT using its enterprise value (EV), which reflects all sources of capital to fund the firm (debt, preferred stock, and common stock). The difference between the firm's EV and its IC (EV-IC) is the market value add (MVA). The higher the firm's ROIC and the more growth opportunities the firm has, the greater the MVA. If the firm's ROIC is equal to the cost of financing the deployed invested capital (referred to as the weighted average cost of capital (WACC) then the firm's EV should be equal to the firms IC as no value is created regardless of growth.
Figure 5 highlights the relationship of EV, IC, MVA, and ROIC by looking at Simon Property Group. Simon Property Group is owned in most REIT ETFs and is the largest REIT by weight in VNQ at just under 10%.
Figure 5: Simon Property Group Enterprise Value
Source: Author Calculations
What should be immediately telling from Figure 5 is that Simon Property Group through organic growth of its properties has been able to increase profits without making any major acquisitions. We can see modest jumps in asset values in 2004 (acquired Chelsea Property Group) and in 2012 (multiple acquisitions including the investment in Klepierre SA).
Therefore the firm's EV/IC ratio (a short hand valuation tool similar to Price-to-Book) has risen to reflect the increased market's valuation of the firm and its underlying properties. The long-term EV/IC average has been 1.7X. With an expanding ROIC, the ratio has been trending up and is currently at 2.2X. The ROIC/WACC ratio (a theoretical Price-to-Book metric which assumes no growth) based on long-term averages is 1.1X and adjusted for the most recent ROIC figure -- 1.3X.
To reiterate, the expansion in Simon Property Group's market multiple since 2002 is likely several fold but can be largely tied to 3 drivers. First, the firm's invested capital has increased 2.1X or approximately 7.0% compounded annually. Second, (and more importantly) the firm has expanded its profitability on its deployed capital. The profitability expansion has provided a 3.1X increase in net operating profits or 11.1% compounded annually.
Lastly, the entire REIT sector has benefited from falling interest rates (as discussed previously). As rates fall, prices rise. Not unsurprising, the firm's enterprise value and equity share price expanded at 14.9%, and 15.2%, respectively. This growth is above both invested capital and operating profit growth.
Our initial valuation thought is that the market is clearly rewarding Simon Property Group for its underlying properties and organic growth. However at 2.2X invested capital and an ROIC of under 10% versus a weighted cost of capital closer to 7%, one would argue shares are fully valued.
Such a scenario has likely been considered by management, when it decided to spin off the smaller regional malls into a new REIT. We would expect more corporate activities this year as management teams look to unlock further growth.
Markets are continuing to feel their way through the current Federal Reserve tapering process. Soft job numbers and weak manufacturing data does not help. As the markets work through their price discovery mechanism, we would expect some level of volatility. Still, with economic fundamentals trending in the right direction, one should think that the REIT group can sustain its recent dividend growth momentum.
With the current yield of the selected group at ~3.40% (~3.69% for the actual index) valuations have improved modestly since our September note. The dividend floor remains at 3.0% which the group touched in Q1'13. The spread to the 10-year is approximately at ~0.8% which is at its decade-plus average. Therefore we would consider recent prices fair and near-term risks geared towards overall market risk than sector specific issues. As long as the economy can continue to grind forward, dividend growth in the 7%-8% range will likely be the main valuation driver over the near-term for the REIT group.
Lastly, Simon Property Group's expansion in profitability and expanding market multiple indicate that we are well into the mid-cycle of the economic expansion and that future accelerated growth based on further profit expansion should be tempered. The recently announced spin-off of selected properties is likely a signal that REITS in general are looking for ways to maintain momentum.