Are REIT's Fairly Valued?

As my readers know, I am short REITs through my ownership of the ProShares UltraShort Real Estate ETF (SRS). On current metrics, REITs look fairly to somewhat overvalued, and not idiotically overvalued as they were a year ago.

Currently, the REIT universe in the Russell 3000 trades at 8.0x funds from operations (FFO - essentially cash flow before capital expenditures, the favorite metric the REIT industry has convinced a gullible Wall Street investment community to follow). Stocks, ex-financials trade at 7.5x FFO. Thus REITs trade at a 7% premium to equities.

REITS should trade at a lower multiple than stocks since REITs must pay most of their earnings in dividends to retain tax-free status and thus, unlike stocks, cannot use internal funds to grow. However, a year ago, REITs were trading at a premium to stocks north of 40%, so valuation is no longer egregious.

Regarding dividends, the yield on the REITs in the iShares Dow Jones Real Estate ETF (IYR), is 5.4%. (The yield on the REITs in the Russell 3000 is 5.9%.) According to Merrill Lynch, REITs have historically traded at a 1.75% premium to the 10-year U.S. Treasury bond. With the 10-year closing at 3.53%, the IYR is trading at a 2% discount to their historically fair value.

However, REITs are trading at fair value dividend yield only because government bonds are extremely low. At a more normalized T-bond 5% yield, REITs are trading at a 25% premium to normalized interest rates. At these levels, the IYR would trade at $52 and the SRS at $138.

Disclosure: The author owns SRS.

Comments

[tl]

So what you're saying is that REITs' prices are being helped by the Fed's rate cuts and other recent liquidity actions. Makes sense. But are REIT stock prices only sensitive to interest rates? What events/conditions could bring down those rosy FFO numbers?

[Frogman]

Huge insider selling on these REITS (days/weeks ago)...HORRIBLE balance sheets..ex: check out GGP ...further dilutive activity because of the freeze in credit markets...REITS issuing more stock (article WSJ yesterday) they have not taken any impairments (inevitable) (check out the MIT Index of Commercial RE Index)
....lending has not come back and count on tighter restriction more equity........I have not seen an opportunity like this in a long time....risk/reward is there....pay more attention to ROA...

I own SRS and adding to position here...

[thesession]

I agree that it helps support some value. One thing to note is that cash flows can also be helped by FED, esp. if that REIT has a high % of floating rate debt to fixed rate debt. The recet decline in Libor can affect 2008 FFO projections upward, but for most REITs, that is likely to be relatively small impact to FFO (assuming they hedge well).

[JacknJill]

REITs did well after the gov printed money like crazy in 2001. The rising REIT values reflected then a 50% loss in the $$ (as compared to hard assets or even $C or EUs). The gov has decided to do it again in 2008 (to salvage the idiots that are mortgaged beyond their means), so the $$ in your pocket will buy much less in 2009. And don't expect the Dems to reverse the trend.
I rather own asset-based stuff than the stinking $$.
Disclosure: I bought IYR at under $60, and I am long gold and a few health REITs (SNH, FVE, etc.)

[johnthebear]

Try this: Chart the Dow Jones Avg for 10 years, compare with NASDAQ, then compare (IYR) the Dow Jones Real Estate Index for the REITs, and last compare (FXI) the China ETF, all on one chart.

Now look at the peak of the REIT's (IYR), that anticipated the depth of the crisis coming our way and the steep down turn of the China market (FXI).

The REIT bubble got higher in July 2007 than the NASDAQ when it topped out at 5,000 in year 2000!

The way to play the continued drop in the DJA real estate REIT bubble is to buy Ultra Short, SRS for a 2:1 advantage on the decline.

And to play the continued deflation of the huge China Bubble, use the mirror image of (FXI) which is (FXP) for a 2:1 advantage, also an ultra short exchange traded fund.

Have you looked at the 200 day moving average of every stock exchange in the world? If you had, you would find every single one below their 200 day average.

Richard Band, was quoted in Market Watch today as predicting a 16,000 DJA by the end of the year!

When you study the chart I suggested above and consider the condition of the world markets and the little reported fact that England, Ireland, Spain, Germany, Japan etc. are all on the verge of recession, it gives one the shakes!

How can anyone project that our market could turn on a dime and rise to 16,000, when every other index in the world says they are headed lower?

We are in for a very hard, long ride down a rough road that could take 10 years to reach bottom with many "dead cat bounces" along the way, just as happened when the tech bubble pooped from 2000-2003. Those false starts are readily visible on the chart. So, fasten your seat belt Mr. Band, and everyone else riding behind him in the cart filled with bull stuff!

[tl]

What about the REITs that are claiming that they have their tenants locked into long-term leases, therefore preventing FFO from decreasing even during a recession?

[cn21713]

The problem I see with that kind of analysis is that the vast majority of the REITs in IYR have values far better than the metrics you are reporting.

These values are being hidden from your analysis by being averaged with the larger cap ones on a market cap weighted basis.

In one way that might make it seem like we could both be right. Suppose the large cap ones are 20% over valued but the small cap ones are 10% undervalued. A reversion to "fair value" would result in the net gain for SRS that you expect, but it would also result in a gain in the REITs I think are undervalued.

There is a problem with this theory. Although I don't like the larger cap REITs exactly because they seem too expensive to me, there is a reason for them being more expensive. They are larger, and some investors will view them as more stable or view them as the 'blue chip' of the REIT universe. (Perhapse in this enviornment they think the are the least likely to fail.)

Anyway, since people asign a premium to these larger cap REITs and since a hand full of these make up about half IYR because of the market cap weighting, it will probably cause resistance to that portion of IYR reverting to "fair value".

Again, I don't invest in those exactly because they seem too expensive, for exactly the reasons you give. So, in a sense I'm with you on that.

But, what's the next steap? Do you think that the premium can come out of the larger cap REITs or do you think that if the larger cap REITs get forced down to an attractive level that the other smaller REITs would be forced down along with them to the point where the smaller ones are way beyond attractive and way undervalued?

I think neither. I think long term there is no way to make the larger, discovered, more popular companys trade at levels that are as attractive as the rest of the sector they are in. Time and time again this will make market cap weighted indexes mediocre over the long term. So, part of my response is that, ya I expect mediocre numbers for a market cap weighted index. Inside a panic you may drive a market cap weighted index down to the point where the value it offers looks "fair", but realize that at that point you have probably driven the smaller components down to a point where they are attractively undervalued.

[gordon]

REITs suffer in a recession because of business BKs, and vacancies rapidly rising, its simple to me, one you owns a business and leased small industrial space for years. There is NO WAY that REITs can maintain dividends, once a big mall-based of commercial space REIT cuts, look out below. Even an ultimate RISE in the 10-yr TBill, because foreigners won't buy US paper, will kill REIT's dividend payouts, add those 2 scenarios together. )don't own SRS, but wouldn't buy IYR here) This recession is only now impacting commercial.

[kerry]

cn, then buy small short large. Unfortunately for you, per Soros' earlier plays on REITs, the large do have an advantage if their stock px is a premium to book value.

fwiw, I agree that the SPGs of the world see their stock px cut. They don't have any protection from the Fed.

imo, the two complications relate to whether the fed can foment inflation (the REITs saving grave) and whether any CRE funding will come going forward(death knell). Note that both of these issues sb layered ontop of Toro's analysis. I think I can see where things will go, but I don't have any urge to bet everything on it.

The way Wall Street is working right now (and given their general completely and utterly lack of sophistication /death wish the last few years), they aren't going to try to forecast. When/if things start to go bad for the REITs, they will die or rally. As things stand, death is more likely but the fed just might be able to sneak in rampant inflation and save them.

[Tony Soprano]

If the SRS goes to $138 I'll be loading up the truck big time. However, it better do it within 3 to 9 months.