I will use Equity Residential (NYSE:EQR) as an example only. A quick look at other REITs suggests a similar story. EQR is big and widely held. Fidelity, for example, owns 7.8% and Vanguard 5.7% so its probably well represented in a portfolio near you.
The first surprise is the yield - it is, against expectations, only 3.5%. Even grossed up for tax that is not automatically compelling. But the real problem needs some deep digging. Let's have a look at the latest 10-K, for the year to December 2005.
EQR owns 926 residential properties in 31 states and D.C., all valued at $13.7 billion. It finances these assets with $8.1 billion of debt/prefs and $4.9 billion in equity. In 2005 EBIT was $512m compared to c.$370m in interest and pref coupons. In other words, ignoring the whole slew of one-offs and after deducting further for minority interests, net income available for the common was only about $70m; peanuts - a return of less than 2% on book. The dividend was $496m, way higher. How come?
Defenders of REITs make two points, one good, one bad. The good one is that net income doesn't capture all of the gain, there is capital appreciation, too. The bad is the notorious FFO, funds from operations. This is a special measure for REITs that adds back depreciation to income. Like all of these non-GAAP treatments it should be viewed sceptically. Depreciation is a real expense, or a real estimate of future expense. In this case it is a provision for future works necessary to maintain the buildings and fixtures on the estate. If there is over depreciation then they should change their depreciation policy.
Happily, there is a way to measure the true value created that takes on board both these arguments and gives an idea of what the sustainable dividend might be. From year end 2002 to 2005, common shareholders' equity grew from $14.3 to $15.7 per share. In addition, the common received $5.2 in dividends. This equates to a compound growth per year of 13.4%, the equivalent of being able to pay $655m on last year's book.
So the good news is that the common dividend is covered, but barely. The bad news is twofold. If capital growth slows or, as seems more likely, reverses, the dividend would be uncovered. More fundamentally, this $655m or so is the total increase in value. There is nothing else to play with, no FFO, no other magic pockets. To value EQR you must focus only on that amount and its effect on the book value of $4.9 billion.
So we come to the crunch. What would you pay for that book and that ability to grow (or not)? The tax benefit is nice but it doesn't make the 3.5% dividend grow any faster. The surprising answer, for the current market at any rate, is $15 billion or over three times book. That is absurd. The capital growth providing most of the dividend/valuation support is far less secure than a third subordinated bond from a highly leveraged buy out. A 13.4% yield for such a bond might give you par or slightly over. But would you pay three times par?
Common shareholders are conniving to keep the stock price up - against themselves.
Here is a handy table showing the largest constituents of each other REIT subsector and their price-to-book values:
Disclosure: Author has no position in stocks mentioned