As the inflation/deflation debate rages on, many investors continue to seek an alternative investment vehicle which can protect them from either outcome. For many, finding this panacea is akin to the quest for the holy grail. However, there are a number of publicly traded Real Estate Investment Trusts (REITs) which may accomplish that objective.
Weak Job Market & Economic Growth Encourages Renting
In the aftermath of the credit bubble, lenders were forced to establish responsible practices for evaluating prospective borrowers. As personal bankruptcies remain elevated, near all time highs, many lack the credit score necessary to qualify for a mortgage. Even among those who qualify, many do not have the cash for a down payment.
Improvements in creditworthiness and cash savings come as a result of job creation and wage increases. The Kansas City Federal Reserve estimates that sustained GDP growth of 3.3% is required just to maintain the current level of unemployment. We have yet to see if such growth is possible without massive government stimulus. With U-6 unemployment at 15.5% (includes discouraged and underemployed) as of April 2011, upward pressure on wages is also unlikely.
Housing No Longer Viewed As An Easy Source of Profit
According to Gary Shilling in his latest Insight newsletter, citing data from the National Association of Realtors and the U.S. Census Bureau, the 2-2.5 million units of supply in excess of normal working inventory could take 4-5 years to work through. Even if a prospective buyer possesses the credit score and cash position needed to obtain a mortgage, these soft market conditions may discourage marginal buyers either because lower prices may present a better entry point or poor liquidity will trap them in their new homes.
Even in a more robust market, any appreciation in home value must be discounted by interest and taxes paid as well as maintenance and utilities. Should the U.S. take away the deductibility of mortgage interest in an attempt to increase tax revenue, the upside potential of home ownership becomes even less attractive.
A Degree Of Inflation Protection
Greenstreet Advisors estimates that a decline from the current homeownership rate of 66.4% to 65% would produce an additional 4.5 million renters. As demand for rental apartments increases, rents naturally increase as well. Investment in multi-family real estate provides investors with exposure to this price increase. Exacerbating this trend is the supply side of the equation, which was adversely impacted by the credit crisis and will accordingly require several years of production to bring about a meaningful increase in units available.
REITs are highly leveraged and can be negatively impacted if rising interest rates or frozen credit markets (i.e. 2008) increase the cost of capital. Also, because REITs must distribute at least 90% of their taxable income in order to avoid corporate income tax, affordable leverage is crucial to growth as reinvesting profits is largely not an option.
Evaluating individual REITs also requires familiarity with valuation tools less frequently used to analyze common stock investments. Earnings and associated metrics are largely irrelevant as a result of the income distribution provision described above. Rather, funds from operations (FFO) and its derivative metrics (AFFO, FFO Yield) are most relevant.
A Look At Some Of The Largest Players
Using three of the largest Residential REITs (earnings call transcripts posted on Seeking Alpha) we can prepare a basic review of 1Q11 valuations using Price-to-FFO, which is similar in nature to the conventional P/E multiple. While these elevated multiples may be an indication of pullback looming, the fundamentals above should drive long-term performance. Though this analysis is far from complete, Apartment Investment & Management Company (NYSE:AIV) appears to offer the cheapest valuation.
|REIT||Ticker||1Q11 FFO (per share)||Price-to-FFO|
|Apartment Investment & Management Company||AIV||$0.39||16.33|