Why Are REITs Trading at a Premium to Stocks?

When I first set out my bearish thesis on commercial real estate, REITs were trading at a 50%-60% premium to stocks. Since then, the REIT ETF, ticker IYR, of which I am short, has fallen from $85 to $79, and valuations have come in, a bit.

On earnings, the valuations have actually gotten worse. On 2007 and 2008 estimates, REITs - as represented by 96% of the REIT market cap in the Russell 3000 - are trading at 29.6x and 26.5x times earnings compared to 28.4x, and 26.1x, five weeks ago. The S&P 500 (SPY), on the other hand, is trading at 16.2x, and 14.6x, 2007, and 2008 earnings. Therefore, based on estimates, REITs trade at an 82% premium to stocks.

The REIT guys say earnings are not the best metric to value REITs because, well, property doesn't depreciate. Instead, the market should value REITs on funds from operation [FFO], which is essentially operating cash flow from the Cash Flow Statement plus depreciation. Leaving aside this spurious logic, REITs currently trade at 12.8x FFO, while stocks trade at 9.2x, a 39% premium over stocks versus 13.8x, and a 50% premium at the end of May.

Historically, REITs have traded at 7x-9x FFO and at a discount to stocks. Today, they are at a substantial premium.

Why?

Stocks retain earnings, and can use internally generated funds to grow, whereas REITs must distribute most of its free cash flow as dividends. Therefore, stocks should trade at a premium to REITs, and not vice-versa.

It's not like dividends are growing for these things in leaps and bounds. Earnings revisions are minor, at best. Rental increases haven't been much to write home about, and credit is getting tighter.

The institutions pouring money into commercial real estate are looking in a rear view mirror, one that is going to look dramatically different over the next five years than it has in the past five years. Investing in real estate at these levels will move institutions away from their actuarial targets, not closer.

A 39% decline takes the IYR down to $48. I intend to add to my short position on any significant bounces.

SPY vs IYR 1-yr chart:

Comments

[Al Rob:]

I think the high multiples simply reflect the high underlying resale values of the properties held by the REITS... So either FFO has to come up through incresed rents/decreased costs to support these levels OR valuations need to come down..

2007 Jul 05 09:50 AM

[Josh Stern:]

Couple points.

1) Going long SRS gives you basically a 2X short of IYR and it even pays a dividend.

2) I agree with you about the valuation, but earnings estimates for REITS seem to be in a healthy uptrend, and Phil Davis' post today confirms the basis for this: seekingalpha.com/artic... . So SRS/IYR short seems too dangerous here.

2007 Jul 05 10:49 AM

[Robert Nabloid:]

REITs are all about dividend income... and many investor's are getting to the age of retirement where they need thier money to pull in regular dividends. Should these investment vehicles not become more popular as more investors retire?

Also, the large Income Trust industry in Canada is coming to an end and all that money will now be flowing to REITs in and outside of Canada.

2007 Jul 05 05:33 PM

[wixeywaxy:]

REITs have a built in contradiction in my opinion. If I were a R.E. expert managing a REIT would I capture the best opportunities for the REIT or would I be inclined to pick those off for my private investment. Oh, you say, that would be unethical. Yes, it would, but nevertheless when big profits are involved people are easily corrupted. Then there is another negative, when people throw so much money into REITs the managers throw the money into very questionable ventures. We see that in too many shopping centers being developed nearby to others not performing all that well. One robs from the other, with the newer sometimes briefly capturing the traffic. No thanks, I won't be placing any of my dollars into any REITs. Vic

2007 Jul 06 10:25 AM

[Living Off ...:]

i'm long SRS which is twice the inverse of IYR.

cap rates on most commercial bldings are at such ridiculous levels that they can't service the debt, let alone pay a dividend. I think the long term trend is down.

2007 Jul 06 07:28 PM

[johnthebear:]

Excellent and accurate, especially 3/08. SRS is still the way to go and excellent for day trading.

I am looking for IYR to hit 59 soon and IYR will soar to 150 and beyond.

The downgrade of Goldman, Lehman and others has the effect of reducing mortgage money through CMBS and and CDOs that will be needed to refinance all those interest only loans that were given out so easily in 2007. Property bought with no equity and expectations of high appreciation at a time when office and shopping centers are increasing their vacancy makes for a very explosive mix.

So I too recommend SRS as the way to play the commercial real estate bubble.

2008 Mar 22 05:51 PM