To start this article I should fully disclose that I believe that the commercial real estate industry and the REIT industry are systemically mispriced and therefore present opportunities to exploit the mispricing and create above market returns. I assert that there should exist a parity relationship between the implied capitalization rate of REITs and the capitalization rate of properties similar to those owned by the REIT sold in the private market after adjusting for an estimated asset management fee. Similarly, there should also exist parity relationships between the implied capitalization rates of REITs that own similar properties in similar markets. The data underlying the assertion of these parity relationships is the foundation of the investment management firm I founded and is beyond the scope of this article.
Implied Capitalization Rate
Many REIT industry practitioners use Funds from Operations per share as a valuation metric instead of the implied cap rate but there is a strong theoretical foundation for looking through the capital structure of a REIT and at the income return generated as a percent of the market implied value of a REIT's assets, which is defined as the implied cap rate. Modigliani and Miller proposed that capital structure is irrelevant to a company's stock valuation with several caveats. The most important being that there are no taxes which is a significant caveat for most corporations but REITs do not pay taxes at the corporate level so this caveat is not relevant for REIT valuation. There are several other caveats but these are judged to be non-material for a non-distressed REIT. This is in effect treating a REIT as a portfolio of properties with accompanying management that charges a general and administrative expense and reports using GAAP.
REITs out of Parity
If one assumes the afore mentioned parity conditions should exist, one can then look to the current pricing of REITs and determine if there exists a mispricing opportunity to exploit this relationship. The most noticeable mispricing that currently exists is between Parkway Properties (NYSE:PKY) and Cousins (NYSE:CUZ).
REIT Market Concentration
To determine the market concentration of a REIT, the preferred metric to use is NOI per market. If a similar cap rate were applied to NOI among all markets, then this metric would represent the REIT's market concentration. Generally lower capitalization rates are applied to NOI generated by buildings in high barrier to entry markets compared to NOI generated by buildings located in low barrier to entry markets which would cause a discrepancy between the NOI concentration by market and the property concentration by market. But in the case of Parkway and Cousins, both REITs own properties exclusively in what would be considered low barrier to entry markets so this should not be an issue.
In the case of the valuation of a single property, one that are more stabilized would be assigned a lower cap rate than one that is less stabilized. But because REITs own numerous properties, the application of the law of big numbers would largely make this irrelevant as a pool of NOI would generally reflect average stabilization.
Finally, it has to be considered that market concentration is at best a guess but reasonable and defendable assumptions can be made to estimate a REIT's market concentration.
Alternative Market Concentration Metrics
Unfortunately not all REITs break their NOI down by market so often other metrics that are provided need to be used. Alternative metrics provide include square feet by market or revenue by market. These metrics are considered inferior to NOI by market but if they are the metrics provided they can also provide a reasonable estimate of a REIT's market concentration.
Parkway Properties Market Concentration
Parkway reports the buildings they own, their square feet, and the market in which the property is located. Using this data, the following is the estimate the market concentration of Parkway.
Cousins Market Concentration
Cousins reports revenue per market. The following is an estimate of Cousins market concentration using revenue.
Market Concentration Comparison
If one compares the market concentration of Cousins and Parkway, one will see that both have their highest market concentration in Houston and the remainder of each of their portfolio is generally spread throughout Southeast markets. What should be noted is that neither REIT owns properties in what would be considered high barrier to entry or "gateway" markets. Examples of these markets are Boston, New York, Washington, D.C., LA, San Francisco, or Seattle. Because Cousins and Parkway are in many of the same markets and both exclusively own property in low barrier to entry markets, their implied cap rates should be in parity with each other.
Implied Cap Rates
The closing stock price of Cousins and Parkway on July 23, 2015 implied a cap rate of 7.22% and 6.28% (see calculation detailed below) respectively or a 94 bp spread. The assumption is that a parity relationship should exist between the implied cap rates as they own similar properties in similar low barrier to entry markets so Cousins is undervalued relative to Parkway and vice versa. To quantify this mispricing, Cousins' stock price would need to rise 22.1% or Parkway's stock price would need to drop 25.0% to achieve implied cap rate parity between them.
One could enter into a market neutral position with Cousins as the long position and Parkway as the short position and seek to exploit this mispricing. One could also employ leverage to exacerbate the effect of these two REITs achieving parity.
Implied Cap Rate Parity Examples
If the existence of the parity conditions asserted in this article seem tough to believe, especially given the implied cap rate metric of REITs which is not commonly used, one should consider the current implied cap rate metrics for the five REITs that own a majority of their properties in New York City.
SL Green, New York Realty Trust, and Empire State Realty Trust
SL Green SLG, New York Realty Trust NYRT, Empire State Realty Trust ESRT own all of their properties in the New York Metropolitan area.
Paramount Group PGRE is a recently listed REIT and as a result, has a bit of a confusing ownership structure of its buildings. Prior to becoming public, PGRE sponsored numerous investment funds and each fund owned a percentage of a building and Paramount Group owned a certain percentage of each fund. As such, the ownership of buildings by market is a bit convoluted but if one calculates the reported NOI generated by each ownership share of each building, you get the following estimated market concentration.
Vornado VNO has a very straight forward ownership structure of its buildings and reports EBITDA by market which is used to estimate its market concentration shown below.
Implied Cap Rates
As shown in the table below, the implied cap rates of REITs that are either solely concentrated in New York City or with a majority of their properties located in New York City are very close to parity with each other.
Implied cap rate parity should exist between REITs that own similar properties in similar markets. Currently Cousins and Parkway are significantly out of implied cap rate parity and this presents an opportunity to exploit the mispricing.
Disclosure: I am/we are short PKY.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.