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REITs (Real Estate Investment Trusts) today are a trap, plain and simple. They are trading well above historical valuations, probably because investors today are desperate for yield. Income investors may be shocked to find that their dividend yield is poor consolation for capital depreciation.

REIT Bubble: 4 Graphs to Save Your Portfolio

Financial metrics for the five REITs with the largest market capitalization which currently have positive earnings are listed below:

Ticker

Company

REIT Industry

Market Cap ($B)

P/E

P/S

P/B

P/FCF

EQR

Equity Residential

Residential

17.0

161.1

8.0

2.9

NA

HCP

HCP

Healthcare

19.7

31.7

10.8

2.1

NA

PSA

Public Storage

Diversified

23.6

44.0

13.2

2.9

100.8

SPG

Simon Property Group

Retail

46.7

30.4

10.3

7.9

87.0

VTR

Ventas

Healthcare

19.1

48.7

8.3

2.0

94.0

These static price multiples should make the hair stand on end. They are very, very high. Supporters of REITs might deny these high valuations by saying that REITs are somehow different and that these higher valuations are nothing to worry about. The idea behind such objections would be based on the (false) assumption that REITs always had such high valuation multiples and that if history is any indications, they always will.

Plots of historical price multiples demonstrate how this assertion about REIT price multiples is pure baloney:

(click to enlarge)REIT Historical PE

(click to enlarge)REIT Historical PS

(click to enlarge)REIT Historical PFCF

(click to enlarge)REIT Historical PFCF

Clearly there has been an expansion of REIT valuation multiples over the past ten years while the equities in the S&P 500 have not experienced such a multiple expansion.

Supporters of REITs might counter by saying that these investments are "safe" and that they are primarily income investments. These retorts are not substantial. First, REITs are equity investments like any other. The residual value of assets minus liabilities on the books of these entities can be worthless, just as they can be for a stock. Market prices of REITs and regular stocks vacillate in price, often with good reason. Clearly, REITs are risk assets.

Moreover, REITs are not compelling dividend investments since many of them have payouts which exceed their earnings. Consider the five REITs in our sample:

Company

Dividend Yield

Payout Ratio

Equity Residential

2.39%

320%

HCP

4.36%

135%

Public Storage

3.19%

130%

Simon Property Group

2.73%

74%

Ventas

3.83%

170%

REIT payouts in excess of 100% are either unsustainable or will hinder dividend growth in the future.

Supply and Demand

Another threat to the REIT bubble could come from a supply glut of new REIT securities. More REITs are hitting the market as CFOs realize that they can pass through taxes and re-position their firms as REITs which trade at much higher valuations. Disparate sectors are spawning non-traditional REITs. Most recently, the board of cloud-computing company Equinix (EQIX) approved a plan to transition into a REIT.

Conclusion

Investors should avoid securities with outlandish valuations and should instead purchase ones that are not in a bubble. Owners of REITs should thin their holdings, and income investors should look elsewhere for yield.

Source: Is There A REIT Bubble?