REITs: An Update

On Thursday evening, I ran the valuation on the REITs. Currently, the Dow Jones Real Estate Index ETF (IYR), is trading at 9.0x funds from operation [FFO]. That is a 15% premium to the S&P500 ex-financials, which is trading at 7.8x FFO.

As I have pointed out in the past, REITs should trade at a discount to stocks, not at a premium. Corporations can retain all their earnings to generate internal growth. REITs have to pay out most of their earnings in dividends and are more reliant upon external sources of financing to fund growth. Thus, REITs should trade at a lower multiple and at a higher dividend yield than stocks.

No FFO discount would put the IYR at $60. A 10% discount to the SP500 would put the IYR in the mid-$50s. IYR closed just below $71 on Thursday.

According to Merrill Lynch (MER), the dividend yield on REITs has averaged 1.75% above the 10-year Treasury bond. Currently, the IYR is yielding 5%. With the 10-year at 3.82%, a 175 basis point premium would put the expected yield at 5.57%. At a dividend yield of 5.57%, the IYR would trade at $63 per share.

However, the 10-year is coming off very low levels. If it rises back to a more normalized level of, say, 5%, that premium will shrink. With a 5% T-bond yield, the expected yield would be 6.75%, and a normalized value for the IYR would be $52, implying a 26% decline.

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Technically, the IYR is running right up against resistance at $71-$72.

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And there have been few strong up days as of late on heavy volume.

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There has been a lot of short covering in the group over the past month.

Disclosure: I am short REITs via my ownership of the ProShares UltraShort REIT ETF (SRS).

Comments

[stc1]

Hey Toro -

Can you provide the sources for your info, most pertitently, your FFO estimates for the IYR and S&P 500, as well as your yield calc for the IYR. These don't gibe at all with what I have. I am long SRS as well, but more as a hedge for my REIT longs (DLR, ARE, DDR, OFC, EXR, OHI, EPR, SKT, VTR, PLD, GGP, SLG, AHT, SHO, NRF) than as a bet against REITs in general. It seemed from your earlier posts that you recognized that IYR is a pretty poor proxy for REITs in general (which I agree with), yet you keep referring to it as a benchmark. I understand if what yo uhave is proprietary, just want to get an idea of where your analysis is coming from. Thanks.

[dunegrass]

I believe the time to short REITs was June of last year, and then again in October. The time to exit a June REIT short was September. The time to exit an October REIT short was the middle of last month (March). I also believe the riskiest time to take any position (short or long) is mid-stance between short and long-term moving averages (which is where we currently are). In the near term, if IYR closes above 73 I would not want to be holding a short position for IYR, regardless the valuations.

[Toro]

stc

The data comes from Bloomberg. I use the components of the IYR and calculate the data using a weighted average. It may not represent the actual IYR. For example, the actual dividend yield for the IYR is lower than what I compile out of Bloomberg. I also similarly compile data for all the REITs in the Russell 3000 and do a similar calculation, which provides slightly but not dramatically different results.

I think the path of least resistance in the near term is up. I had written not too long ago that I did not think REITs would underperform the broad market, and that I was using it as a market hedge as much as anything. However, since the Dow Jones US Real Estate index is up over double the market since it hit its low in January, I am beginning to think it will underperform over the intermediate term.

[tl]

Toro, you've owned SRS for a while now. Do you realize the nasty value decay that holding an ultrashort hands you? I only realized this after watching SRS for several months. As you wait for REITs to finally admit weakness (at least by their stock prices), your SRS holdings fall in value even if IYR is flat over time.

I think you're right: REIT stocks will ultimately correct. But while you wait to be proven right, your SRS falls further. Maybe shorting IYR is the smarter play -- but there are obvious risks doing that as well.

[Larry Gagnonl]

Anyone have any thoughts on MPG? It is a REIT with a high dividend which has stopped having press conferences.
Strange.

Larry [e-mail]

[stc1]

Thanks for the response Toro. I do a similar analysis, using the entire equity REIT universe (no mortgage REITs, no timber), adding in the small caps and new issues that don't show up in IYR but taking out the special situations, like MPG, MSW and PPS (for now), that do. Also, I don't use market cap weighting like IYR, which obviously skews both the yield and the multiple, just simple equal weights. That said, my FFO multiple calc is much higher, at 13.1x; my yield though is also higher at 5.6%. Where do you get the S&P FFO number? Thanks again for the analysis and response.

P.S. Larry, I'd avoid MPG. It's in serious trouble with the refi of its acquisition debt and will likely be broken up or sold on unattractive terms.

[johnthebear]

Toro, I hope you are right in your projections for the fall of IYR. I am currently caught in a trap without an early stop loss. I am afraid of whiplash now.

I was looking at the dates for earnings reports and the next couple of weeks should really turn things down for IYR based on the expected earnings reported by Scottrade. What is your expecation of earnings in the near term?

Your analysis gives me confidence, but I wonder about your follow up comments of "underperform&quo... Where did that come from? Your scaring me now! I am not sure what you are saying and the time horizion you are considering. Please help me out here. Thanks, John

[Toro]

tl

Your point is well taken. If you have the flexibility and the skill to trade around the position and add value that way, good for you. Due to restrictions at my firm, I can't jump in and out of positions. Also, it is not my initial position. I went massively short REITs last winter, covered in January then re-established a smaller position in February. I was looking to cover in March but the SRS didn't hit $130 as I expected. I have tended to do pretty well being value conscious, but it didn't work out that way.


stc

I calculate FFO by downloading components to calculate the metric from Bloomberg. Maybe I'm doing it wrong, I don't know. But I am more interested in how they compare to stocks, as well as using other metrics such as dividend yield, cash flow, etc. I have also found over the years that FFO can differ from analyst to analyst, just like the term "free cash flow" often does. Goldman put out a piece during the week saying REIT FFO was 16x, which is helluva lot different than mine, and stating that historically, REITs have traded at 10x-11x, so they think valuation is even more stretched than I do. Obviously, use the calculation that works best for you.


John

I'm not sure what the time frame is, other than to say I think the market is in a trading range for a couple of years, maybe with a downward bias. There certainly could be more upside from here as the path of least resistance is up at the moment. I think earnings will come in weaker than expected over the year as analysts are expecting growth of ~5%. I think that is too high given the current environment. I don't believe any economic collapse is coming, but I think the economy will move in fits and starts and grow below trend for some time. On underperformance, REITs have returned double the market since they hit their low in January. Of course, they fell over 40% in 2007, but that was after a monster run the previous five years. A month ago, I thought that REITs would probably trade in line or so with the market as valuations had gone from being idiotic last year to a bit expensive. Now they are getting expensive again. I think investors are going to be sorely disappointed in the IRRs investing in real estate, and expect stocks to outperform REIT over the next ~5 years.

T.

[tl]

I believe much of what propelled REITs since January was the absolutely unexpectedly massive rate cuts by the Fed. That changed the game completely. Now REITs's yields actually look attractive. My concern with holding a position in SRS is that rates are not likely to rise in the near term, so REITs would have to report serious earnings disappointments in the near term for SRS to perform.

[johnthebear]

Looks like rate cuts are over and the natural supply and demand for capital take over for the near term. That means rising interest rates and cap rates that result in lower values for commercial real estate.

That is coupled with higher vacancy rates that are becoming more wide spread across the nation. The next earnings period should reveal more problems that will result in lower earnings and higher values for SRS. I am looking for IYR to hit 60 by mid summer which brings SRS to the 120 area.

I think we will see a lot more efforts by the REITs to sell stock to raise capital to finance more purchases of distressed property. While that may be successful as an investment strategy, the upper revisions of cap rates will surely take a toll on values.. that is if they are honest in marking to market their values at the end of each quarter. I wonder about that. Lets hear your thoughts.