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While the valuation of the broad stock market is unlikely to inhibit further near-term gains, the REIT asset class appears to have reached a valuation extreme that is likely to prevent any further appreciation without a sizable correction. REITs produced very strong total return gains during January, pushing the asset class further into record valuation territory.

The Wilshire REIT index delivered a total return of 8.9% in January versus 1.5% for the S&P 500. This impressive opening to 2007 comes after REITs just completed in 2006 their seventh consecutive year of out performance versus the S&P 500. With news of the bidding war for Equity Office Properties (EOP), one of the largest REITs, prominent in the news for much of the month, it is not surprising that REITs produced very strong returns during January.

The richly valued EOP leveraged buyout provided REIT investors with a new set of valuation parameters to apply to the publicly traded REIT universe. As Barron’s reported, the $39 billion EOP buyout brings together in a single transaction some of the most powerful financial trends in the markets today, including the mania for commercial real estate, the strength of private-equity firms, and the extraordinary liquidity in the debt markets.

Blackstone, the private equity firm that won the bidding war for EOP, plans to finance the transaction with a staggering $31 billion of debt, a $3.5 billion bridge loan and only $3.65 billion of equity. According to the valuation measures we track, REITs look extremely over-valued, but they have looked this way for quite some time and that has not stopped the asset class from continuing to appreciate.

An additional valuation measure used when evaluating REITs is the Price/AFFO ratio. AFFO, which stands for adjusted funds from operations, is comparable to measures of cash flow for publicly traded entities that pay corporate income taxes, which REITs do not. Currently, the average Price/AFFO for REITs is 18.8x. This is the highest Price/AFFO multiple ever recorded for REITs. It is 33% higher than the 12.6x average historical Price/AFFO ratio over the past 10 years. It is also 38% higher than the current 11.7x Price/Cash Flow ratio for the S&P 500.

Source: REITs Reaching Record Valuation, Headed For Correction