Deep Thoughts Following The Recent REIT Rout

Includes: EPR, ESS, GGP, O, SPG, VTR
by: Adam Aloisi

The following performance chart says it all - REITs of all types have had the wind taken out of their sails over the past two weeks.

REIT High Price 5/22 Closing Price 5/31 Percent Lost Dividend Years Lost
Realty Income (NYSE:O) 55.48 45.45 18.1% ~4.5
Simon (NYSE:SPG) 182.45 166.44 8.8% ~3.5
Ventas (NYSE:VTR) 84.10 71.32 15.2% ~4.75
Essex (NYSE:ESS) 171.11 158.37 7.4% ~2.6
EPR (NYSE:EPR) 61.18 52.42 14.3% ~2.77

Reasons For the Decline

While many seem to think that fear of an end to QE and higher interest rates led to the recent decline, I'm more of the opinion that this was simply a needed valuation correction sparked by "Fedspeak." Fundamentals continue to bode positively for REIT expansion, however, as I've stated previously, the sector was getting ahead of itself. The interest rate "noise" gave momentum investors and others reason to bail or lighten up on REITs that from a near-term perspective clearly had an increasing capital risk profile.

But now that the forward perception of the sector has turned negative, I think it may be a somewhat difficult stereotype to shake until we get more forward clarity from the Fed and / or color from REITs themselves. I'm of the opinion that a slow, calculated upward move in rates might only have a mild impact upon the space in general. A more aggressive stance, which I consider unlikely at this juncture, would certainly be more reason for concern-- especially for those REITs with higher borrowing costs and elevated general leverage.

Lessons Learned

Looking at the above chart, I think the last column is most telling. If an investor were unlucky enough to have purchased Realty Income at its high price on May 22 at a yield point of 3.91%, or Ventas at a yield point of 3.2%, in the short span of six days they would have, from a capital perspective, lost more than 4.5 years worth of dividend income. For the long-term investor, timing may not be everything, and these stocks probably will rebound over time, but nonetheless calls to attention the risks involved in REITs.

Keep in mind that during the '08-09 financial crisis, many REITs lost more than 50% of their value as capital flow seized up. The value of their tangible assets did not drop anywhere near that much, but the perception was that the REIT operational environment, predicated on secondary stock offerings and debt refinancing, was in deep distress. Indeed, the nation's second largest mall operator, General Growth Properties (NYSE:GGP), was forced into bankruptcy in April of 2009 as it could not refinance its debt. Most REITs obviously did not suffer such a fate, but it serves as a very real reminder of what can happen.

Today's operational environment is much more open and different than five years ago, but that doesn't mean that risk still doesn't abound when you buy into a REIT. Not only are you purchasing real estate in a simple package, but you're purchasing the REIT's management expertise (or lack thereof), its debt, and its ability to navigate and grow its business through varying macroeconomic environments. You're also subject to the frothy and finicky nature of both real estate and equity markets. Though REITs are a simple way to invest in real estate, I would argue that the nuances of the vehicle make it probably one of the most difficult for investors to assess and value.

Near-term Outlook And Conclusion

Though most REITs have suffered a 10-20% haircut over the near-term, I would still argue for caution and selectivity when taking a position for either its income or total return potential at this juncture. With investors appearing to cast a wary eye on the group, I don't see much of a catalyst for a broad-based snapback rally. This especially holds true for REITs with elevated FFO multiples and meager growth outlooks - there I see continued downside as investors continue to scrutinize valuations.

As part of a diversified income or total return portfolio, I still believe REITs have their place. Like everyone else who owns them, I've taken my lumps near-term, but am not panicking, merely doing some watchful waiting over the past week. Just like all real estate markets, sometimes it's the buyers, and sometimes it's the sellers in the driver's seat. Sellers have the 'pedal to the metal' right now, but as pricing gets more attractive, the buyers will come.

Disclosure: I am long EPR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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.