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The move in REITs since the beginning of 2009 has been nothing short of spectacular. Shopping centers, apartments, hotels, healthcare facilities, storage operations - there has been a tide that has lifted boats of all shapes and sizes. The attraction has been manifold. First, the sector was beaten down unnecessarily as part of last decade's financial crisis, creating extraordinary buying opportunity, and secondly, there was a flight to attractive sector payouts because of increasingly non-existent risk-free yield. However, after a three-and-a-half year run where tremendous capital gains have been reaped, but dividend yields sliced, investors will be hard-pressed to find encore performances in the years ahead.

This is not to say that the sector is about to crumble. Far from it. REITs provide a solid, diversified, convenient platform on which retail investors can participate in the opportunities associated with real estate operational growth and rents. And many of these entities are firing on all cylinders, showing double-digit revenue and FFO growth. But, even good companies can make for sub-par investments when valuations start creeping up. And that appears to be the case with many REITs.

The Run-Up

Below is a chart tracking historical stock price and yield for a diverse group of widely held REITs since March 6, 2009. I decided to track mall owner Simon Property (SPG), Public Storage (PSA), healthcare facilities kingpin Health Care REIT (HCN), and two apartment landlords, AvalonBay (AVB) and Equity Residential (EQR)

StockIntraday low 3.6.09Closing Price 9.6.12Yield 3.6.09Yield 9.6.12
SPG$24.27$158.879.88%2.64%
PSA$45.35$147.314.85%2.98%
HCN$25.86$59.1610.52%5.00%
AVB$38.34$143.369.31%2.70%
EQR

$15.68

$60.7211.38%2.22%

The theme is fairly resonant. A large move in stock price, anywhere from a doubling to a six-bagger, and a decline in yield, anywhere between a halving to an 80% decline.

While these numbers are telling, one might describe them as somewhat deceptive. On March 6, 2009, there was panic swirling Wall Street as most stocks with a financial sector bent, REITs included, were punished as part of the nation's banking meltdown. Still, it illustrates the dramatic swing the sector has seen over the past 3.5 years.

The Valuation Low-Down

The next chart shows this year's per share FFO guidance, associated Price/FFO, and Price to Book (MRQ), in an attempt to illustrate comparable valuation amongst the five names. I utilized the midpoint of each company's guidance range and a TTM number for PSA because I couldn't access the company's guidance anywhere. Price to book was calculated as market cap divided by company equity.

Stock'12 FFO GuidancePrice/FFOPrice/Book
SPG$7.65216.5
PSA$5.80(TTM)253.0
HCN$3.60161.6
AVB$5.45262.8
EQR$2.75213.1

With the S&P 500 trading at about 15X earnings, each of the five REITs is trading at a premium-to-S&P valuation, with AvalonBay and Public Storage really punching through the clouds. Simon appears stratospheric when valuing it on a price/book basis, with HCN showing the most reasonable value in both metrics.

Still, if we were to assume that these companies can continue to grow FFO in the mid-teens, which they have been doing (with the exception of HCN), perhaps the valuations are reasonable. But, that could be a big if.

The Realty Income Merger

For further examination of valuation in the space, I took a look at Realty Income's (O) proposed purchase of American Capital Realty Trust (ARCT), an all stock deal with a meager 2.1% attached premium. Prior to the announcement of the deal, ARCT said it would post FFO of roughly 76 cents a share in 2012 and had guided the Street 13% higher for next year. This would equate to a price equaling 16X '12 FFO. Book value for ARCT is about 1.75. Compare this to Realty Income which trades at a multiple of 21X 2012 expected FFO and price/book of about 2.5.

The initial takeaway from this is that ARCT management was willing to accept a low premium for its rapidly growing business. Based on this, I think we can conclude one or more of the following:

  1. 16X FFO is considered a "fair" multiple currently for a growing REIT business
  2. ARCT should have asked for a higher premium
  3. O got a great deal
  4. The five REITs in the chart above are all overvalued

Based on this merger alone and how the other major players are trading, I'm inclined to think that points 2, 3, and 4 have merit, but I'm merely taking a look at the valuation of the players involved and comparing their valuations to the five stocks we looked at above.

Where I Stand

The long-term operating fundamentals for REITs appear positive, but valuations have become somewhat lofty in my opinion. Personally, I have modest exposure to the space through Tanger Factory Outlet (SKT) and American Campus Communities (ACC), as well as a position in the Alpine Global Premier Properties Fund (AWP). I continue to like prospects for these positions, but have recently pared back on ACC, which at 23X '12 FFO is pricey. Tanger, which trades at a somewhat more palatable 20X FFO, I am holding, but won't be adding to considering its anemic 2.65% yield. The Alpine Fund which I bought earlier this year at a tremendous discount to NAV, has seen the discount close, and at this point is not one I'd be aggressively allocating capital to.

As far as the five REITs I covered above, I'd be inclined to trim large positions and probably wouldn't be in a rush to start new ones. Although HCN could be interesting going forward, as it digests its purchase of Sunrise Senior Living (SRZ) and a rash of other, smaller acquisitions. While fundamentals seem strong, should rates turn on a dime, the entire group would become much less desirable. Stocks trading at 20+ FFO multiples and possessing sub 3% payout yields, could quickly become expendable in institutional and retail investor portfolios.

If you are contemplating purchase of a REIT in this market, pay careful attention to Price/FFO valuation, expected growth, and don't overweight shares in either an income or total return geared portfolio. While investors may continue to see decent total return here, expectations should be tempered, as valuations and associated capital risk continue to escalate.

Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.

Source: REITs: Strong Fundamental Foundations, Hazy Valuation Skylines