REITs: No Longer Over-Valued

I have been vocally bearish on commercial real estate for some time, as evidenced here, here, here, here, here, and here. The reasons for my bearishness were simple - valuations were insane and investors were manic.

Investors certainly are no longer manic, with transactions in commercial real estate having collapsed. And with the Dow Jones U.S. Real Estate Index down 40% from its high last year to the low on Wednesday, REITs are no longer ridiculously expensive.

At the height of the mania, REITs were trading at a 50% premium to stocks based on funds from operation (FFO), the preferred valuation metric used by REIT investors. As I noted in the past, this valuation was ridiculous given that trusts must pay out most of their earnings as dividends and do not have the same access to internally generated funds to grow as do corporations.

That valuation gap has closed. The capitalization-weighted FFO for 114 REITs in the Russell 3000 Index (IWV) that account for 96% of the REIT weighting in the index is currently 9.0x. FFO for the S&P 500 (SPY) excluding financials is also 9.0x.

REITs should trade at a lower valuation than stocks. However, given that REIT FFO has fallen from 14x last year to 9x today whereas stocks have traded at about 9x FFO during that time, one can no longer conclude that REIT valuations are insane.

Also, as the trusts have fallen in price, the dividend yield has risen. At one time yielding around 4%, the cap-weighted yield of the aforementioned 114 REITs is now 6.3%, and approaching the historical average.

Therefore I have substantially reduced my REIT short, having sold down my position earlier this week. I am still short REITs with a significant weighting, but no longer massively so, having reduced my position by about 80% from its highest weight.

I expect REITs will continue to fall, as the playbook is usually to go from stupid over-valuation to stupid under-valuation. But the trade is no longer the slam-dunk it was nine months ago as valuations have come down to reasonable levels. However, as the economy goes into a recession, and as the market continues to find new lows throughout the year, REITs will succumb to the pressure and continue to sell-off.

I have recently been playing the short side through the ProShares UltraShort Real Estate ETF (SRS). If the price falls to $100-$110, I will reload at least a portion of the short position, and sell when in the $140 range, all else being equal.

Comments

[miltyboy]

enlightening

[JohnB]

nice trades

[Georealist]

OK..I give up...How can REITs continue to fall..and SRS..which is a "short" position against real estate..also fall to the 100-110 range??? It is currently around 130...This article is anything but enlightening..it's a High School level piece of self puffery. Toro is boro.

[Long-ShortGuy]

Great call.

Georealist: I think he meant that IF the short ETF falls (ie. REITs trade back up), then he'll re-initiate his short position by buying the short ETF again.

[folklife]

Hey, Toro...Good Call. Going short is not my idea of fun but picking up a few REITS (not mortgage paper companies) seems to be a great idea. I'll get good dividends while the stock rise over the next 7 year cycle. And, BTW, I own commercial real estate too.

[Toro]

Georealist

Sorry for not being clearer. The ProShares UltraShort ETFs give you short exposure when you buy the ETF. Thus, if REITs rise, then the value of the SRS falls, which is why I say I'll buy the SRS when it hits $100-$110.

Hope that helps.

T.

[outersquare]

are the yields and valuations for REITs rearward looking?
that is will yields fall as we enter a recessionary environment?

[Phil P]

Prescient and very accurate given this morning's drop in SRS. I've placed a stop near today's low in case it is a consolidation at 126 -140, but the bearish engulfing candle which has formed as of 1:30P says otherwise.