For the first half of 2013, real estate investment trusts (REITs) such as Health Care REIT (NYSE:HCN), HCP (NYSE:HCP), and Realty Income (NYSE:O) could do no wrong. Stock prices (and by extension, valuations) of these three soared as investors poured cash into anything with a juicy yield. Each of these stocks sports dividend yields near or above 5%, which was extremely attractive to investors in a low interest rate environment.
Since May, the performance of these REITs in comparison to the broader market has been the complete opposite. Health Care REIT, HCP, and Realty Income have gotten crushed to the extent that all three now significantly lag behind the S&P 500 in year-to-date performance.
As a result, investors may have the buying opportunity that, just a few months ago, they could only dream of.
At long last, down-to-earth valuations
As Health Care REIT, HCP, and Realty Income climbed to begin 2013, so too did the multiples investors were forced to pay. A common metric that investors use when evaluating REITs is funds from operations (FFO), which is essentially a non-GAAP equivalent to earnings per share. Using this, we can see just how richly these stocks were trading.
For example, Health Care REIT earned $3.52 per diluted share in funds from operations last year and guided investors to expect $3.75 per share this year. At its 2013 high of $79 per share, Health Care REIT exchanged hands for a whopping 22 times trailing FFO and 21 times forward FFO.
Valuations were equally bloated for HCP and Realty Income. HCP earned $2.78 in FFO last year and expects 2013 FFO to come in at $2.99 at the midpoint of its 2013 guidance range. That means that at its 2013 high, HCP was trading for 20 times and 18 times trailing and forward FFO, respectively.
Realty Income's valuation was even loftier: After rising to $55 per share, the company held a high 27 times trailing FFO multiple and 23 times forward FFO multiple.
Fast forward to today, and these stocks look much more appealing than they did just a few months ago. At recent prices, Health Care REIT, HCP, and Realty Income trade for much more modest forward price-to-FFO multiples of 16, 13, and 16, respectively.
A unique risk for HCP
HCP carries an additional risk that investors should be aware of, which explains why it's cheaper than Health Care REIT and Realty Income. The company announced it had abruptly fired Chairman and Chief Executive Officer James Flaherty and quickly named Lauralee Martin has his replacement. Flaherty had been CEO since 2003, and it remains to be seen what, if any, aspects of the business will change with a new incoming chief executive.
For what it's worth, Martin has been on HCP's board for five years, so it's probably safe to assume she has a well-established understanding of HCP and its strategic priorities going forward. As a result, I don't believe investors should be overly concerned with the news. That being said, the market clearly does not agree with me, as HCP fell nearly 5% on the day of the announcement.
The time to buy is now
The best time to buy high-quality stocks is when nobody else wants to. The market is clearly panicking about real estate investment trusts because of higher interest rates.
It's absolutely true that higher interest rates will result in rising costs of capital for companies that heavily utilize debt, and REITs definitely fall into that category. Of course, there's an opposing argument to be made, which is that higher interest rates signify a stronger economy overall, which will mean better operating conditions for the businesses that comprise these REITs' tenancies.
Plus, lower stock prices mean more advantageous buying opportunities for new investors -- thanks to lower valuations and higher dividend yields. As a result, investors should view the declines in Health Care REIT, HCP, and Realty Income as blessings in disguise.
Bob Ciura has no position in any stocks mentioned. The Motley Fool recommends Health Care REIT. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.