REITs: No Longer Over-Valued

Includes: IWV, IYR, SPY, SRS
by: Toro

I have been vocally bearish on commercial real estate for some time, as evidenced here, here, here, here, here, and here. The reasons for my bearishness were simple - valuations were insane and investors were manic.

Investors certainly are no longer manic, with transactions in commercial real estate having collapsed. And with the Dow Jones U.S. Real Estate Index down 40% from its high last year to the low on Wednesday, REITs are no longer ridiculously expensive.

At the height of the mania, REITs were trading at a 50% premium to stocks based on funds from operation (FFO), the preferred valuation metric used by REIT investors. As I noted in the past, this valuation was ridiculous given that trusts must pay out most of their earnings as dividends and do not have the same access to internally generated funds to grow as do corporations.

That valuation gap has closed. The capitalization-weighted FFO for 114 REITs in the Russell 3000 Index (NYSEARCA:IWV) that account for 96% of the REIT weighting in the index is currently 9.0x. FFO for the S&P 500 (NYSEARCA:SPY) excluding financials is also 9.0x.

REITs should trade at a lower valuation than stocks. However, given that REIT FFO has fallen from 14x last year to 9x today whereas stocks have traded at about 9x FFO during that time, one can no longer conclude that REIT valuations are insane.

Also, as the trusts have fallen in price, the dividend yield has risen. At one time yielding around 4%, the cap-weighted yield of the aforementioned 114 REITs is now 6.3%, and approaching the historical average.

Therefore I have substantially reduced my REIT short, having sold down my position earlier this week. I am still short REITs with a significant weighting, but no longer massively so, having reduced my position by about 80% from its highest weight.

I expect REITs will continue to fall, as the playbook is usually to go from stupid over-valuation to stupid under-valuation. But the trade is no longer the slam-dunk it was nine months ago as valuations have come down to reasonable levels. However, as the economy goes into a recession, and as the market continues to find new lows throughout the year, REITs will succumb to the pressure and continue to sell-off.

I have recently been playing the short side through the ProShares UltraShort Real Estate ETF (NYSEARCA:SRS). If the price falls to $100-$110, I will reload at least a portion of the short position, and sell when in the $140 range, all else being equal.

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