Background on Relative Valuation Model
We introduce our readers to our new relative valuation model. Our relative valuation model is based on free cash flow (NYSE:FCF) which, along with Net Asset Value, are the two most important metrics for real estate investors. Free Cash Flow , also called Cash Available for Distribution (NYSEARCA:CAD) or Adjusted Funds from Operations (AFFO), is a measure of the actual cash flow available to distribute to shareholders after capital expenditures.
We evaluate REITs based on both absolute and relative metrics. On the absolute level, we compare current REIT FCF multiples to historic FCF multiples. On the relative level, we recognize that REITs must be evaluated based on the current available investment alternatives. We analyze FCF yield spreads to other benchmark yield spreads in the treasury bond, credit bond, and equities markets. We focus on the post-recession period beginning in 2010.
We plan to update this relative valuation model for our readers every month. We encourage readers to follow our Seeking Alpha page above to stay up to date with the current state of REIT valuations.
The Best of Times and the Worst of Times
REIT investors have been on a roller coaster ride in 2016. As we pointed out in our last Real Estate Weekly Review the REIT ETF indexes (VNQ and IYR), propelled by declining US bond yields, reached a record high on August 1st of this year: at the time a 18% YTD gain.
Since early August, REITs have retraced nearly 12% of their YTD gain as bond yields have increased while correlations between REITs and yields have reached levels not seen since the "Taper Tantrum" of late 2013. REITs broke through their 50 day moving average last week for the first time since February of this year.
We examine FCF multiples to evaluate REITs on an absolute basis.
During the run-up to record highs in June through August of this year, REIT FCF multiples extended to levels unseen since the end of the recession. The post-recession FCF multiple for REITs is roughly 21x. During the record highs of August, FCF multiples extended above 23.5x.
Currently, REITs trade at a 20.5x FCF multiple, which is below its post-recession average for the first time in nearly a year. On an absolute level, REITs are the cheapest they have been since late 2015.
Examined a different way, we flip the chart above to look at FCF yields rather than multiples. REITs currently trade at an FCF yield of 4.83% which is above the post-recession average of 4.8%. In the post-recession period, REITs have traded in a range of 4.3% to 5.3%.
FCF Spreads to Benchmarks
We look at FCF yield spreads to evaluate REITs on a relative basis. For the 10-year benchmark yield, we use data from the Federal Reserve Bank of St. Louis, and for the S&P earnings yield, we use data provided by Multipl.com.
(Federal Reserve Bank of St. Louis, Hoya Capital Real Estate, Multipl.com)
First, we look at FCF yield spreads relative to the 10-Year yield. Since 2010, REIT FCF yields have traded for an average spread to the 10-year of just over 2.7%. Currently, REITs yield 3.2% above the 10-Year, which is approaching its cyclical high and is now at the cheapest level since before the "Taper Tantrum" of 2013.
Next, we look at REITs compared to the broad equity market. The average post-recession spread between the S&P earnings yield and REIT FCF yields is -0.5%. The current spread is nearly 1%. Compared to the S&P 500 earnings yield, REITs have never been cheaper in the post-recession period.
FCF Spreads to Credit
Historically, REITs have traded in close correlation with investment grade and high yield bonds, perhaps their most relevant capital market alternatives. The risk profile of REITs, based on historical levels, is slightly higher than investment grade bonds but lower than high yield bonds. For IG and HY benchmarks, we use the Merrill Lynch BBB Corporate Effective Yield and the Merrill Lynch High Yield Effective Yield, respectively.
(Federal Reserve Bank of St. Louis, Bank of America, Hoya Capital Real Estate)
The post-recession average spread between FCF yields and investment grade yields is roughly 1.1%. The current spread is now 1.8%: the highest level since early 2013. Based on IG yields, REITs are the cheapest they have been in nearly four years. The similar average for high yield bonds is roughly -2%. The current FCF-high yield spread is now -1.2%, which is the cheapest level since mid-2015.
We note that FCF-based metrics are just one valuation tool in a REIT investor's toolbox. The current levels of these multiples signal that REITs may have over-corrected during the recent selloff. As we note every week, real estate fundamentals remain strong with moderating construction and continued strong demand.
There is one important caveat with all of these metrics. There is a significant portion of market participants that strongly believe that in this post-recession period, interest rates have been held down by central banks to yields far below their fair market levels. These investors believe that as central banks pull-back these stimulus measures, the "risk-free" yield will quickly rise, which will make these "bond-alternative" investments far less attractive. These sharp sell offs in bond alternatives during the last two months and during the taper tantrum reflect this fear.
We do not subscribe to this theory. Medium and long-term interest rates are a reflection of three factors: economic growth, inflation, and a risk premium for the uncertainty related to growth and inflation. While a rise in the short-term rates do have a near-term impact on longer-term yields, we have yet to see a compelling reason to believe that any of those three variables is being significantly misrepresented by the current level of interest rates. In other words, in a world without central banks, we believe that longer-term interest rates would not be materially different than the current levels.
As such, during these periods of interest rate uncertainty, REIT investors demand a higher risk premium, which drives down share prices, resulting in higher yield spreads between capital market alternatives. During the prior Fed rate hike last year, REITs sold off sharply while expectations for a hike reached near-certainty. After reaching the 70% implied certainty threshold (as they have now for a December hike), REITs began to recover and rallied in the immediate aftermath of the announcement of the rate hike.
We believe a similar dynamic may be occurring now.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: All of our research is for educational purpose only, always provided free of charge exclusively on Seeking Alpha. Recommendations and commentary are purely theoretical and not intended as investment advice. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. For investment advice, consult your financial advisor.