Post of the Day
November 29, 1999
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why do reits seem out of favor on the market
Xylophone, we all have our own opinions on this; here are mine:
First, REIT stocks have delivered 12.6% average annual total returns to investors over the past 20 years (per NAREIT data), and have generally been regarded as safe and conservative investments due to the stable and predictable cash flow streams available on most property types. However, things went badly out of kilter commencing in 1994. In that year, REIT organizations began to take advantage of a once-in-a-lifetime buying opportunity caused by the real estate depression of a few years previous, and began raising lots of equity to acquire real estate at attractive prices.
Investors began to anticipate much more rapid growth in FFO (funds from operations, the common (though somewhat flawed) measurement of cash flows for REITs), and bid their shares up sharply. Total returns were 15.3% in '95, 35.3% in '96 and 20.3% in '97, while we saw a major influx in new REIT investors who expected REITs' double-digit FFO growth to continue for at least a few more years. Unfortunately, by 1997 it was becoming apparent that the real estate markets had improved markedly, and that REITs were having to compete with all sorts of other buyers; real estate prices rose, making it impossible for REITs to find great deals. As a result, growth rates would be slowing to a more normal pace.
|"From the beginning of '97 through mid-'98, REITs raised $49 billion in new equity..."|
From the beginning of '97 through mid-'98, REITs raised $49 billion in new equity (a 54% increase in the market cap of the REIT industry), believing that these shares were being issued to long-term investors who believed in the REIT industry. And these funds were invested in reasonably good properties at decent prices (although there were some instances of over payment). Unfortunately, many of these investors were "closet traders," and began to sell the shares when a slowing of the growth rates became apparent. The elimination by Congress of special "paired-share" treatment by which a few well-known and rapidly-growing REITs were "grandfathered" with special tax treatment didn't help.
So, the selling began. It commenced as early as October 1997 (which, with hindsight, was the top of the REIT market) and continued with a vengeance in '98, when the REIT industry dished out negative total returns averaging 17%, the worst performance since 1974. On a price-only basis, the decline was closer to 24%. This performance caused many to wonder whether REITs were truly defensive investments. Since many REIT investors were new to the industry, they didn't have much patience with such poor performance, nor did they want to wait around to find out where REITs' FFO growth would bottom out.
The selling has continued throughout 1999, as shares in REIT mutual funds have been heavily redeemed ($1.21 billion so far in '99, compared with $924 million last year) and unit investment trusts are being liquidated; we are now seeing tax loss selling. (I should add that in almost all cases the REITs were reporting solid FFO growth, actually a bit in excess of analysts' expectations.)
On the other side of the investment world, it's likely that many institutional investors, such as pension funds, significantly slowed their investments in REITs. They had been taking a close look at REITs -- and investing in them -- viewing REITs as an intelligent way to own real estate due to its "transparency" (public disclosure, alignment of management's interests with those of the shareholders, strong insider stock ownership, etc), liquidity and proven management teams. But perhaps they decided that negative 17% total returns didn't correlate too well with the performance of direct real estate holdings and, in all likelihood, have been very slow to add to their REIT holdings.
Then there were some major blunders by some high-profile REIT organizations, such as Patriot American (now Wyndham) and Meditrust, who took on excessive amounts of debt with near-term maturities. The former barely escaped bankruptcy, thanks to some very expensive equity, and the latter will, most likely, have to cut its dividend. Meanwhile, there were some deals pulled off by a few REITs whose managements are taking their companies private which have left a bad taste with investors. Under the circumstances, they had no desire to take the time or effort to sort out the bad guys from the rest of the industry, and decided that REIT stocks were just not worth the bother, especially as they've been such lousy performers.
Finally, REIT stocks are value, yield and small cap investments, and that's just not the place to be right now. This year in particular, funds are flowing only into Internet, tech and other growth stocks; the last time I looked at the Dow Jones and S&P Utility indices, they were each down by 7-8%, and value stocks were performing poorly. To make matters worse, interest rates have been rising all year. Individual investors don't care much about yield today, as they're scoring (at least for now) 50% a year on their wondrous investments. Meanwhile, mutual funds, being so focused on performance, cannot afford to invest in REIT stocks; they're not going up, and if they don't participate in the party they'll end up with no assets with which to buy anything and their managers will be collecting unemployment.
|"The irony, of course, is that the REITs, as opposed to their stocks, are doing quite well."|
The irony, of course, is that the REITs, as opposed to their stocks, are doing quite well. Although FFO growth is continuing to slow (double digit last year, 9% this year and about 7-8% next year), this is still pretty good performance, particularly by historical standards. REIT managements are not, in most cases, levering up with more debt in order to goose growth rates; rather, they are focusing on property leasing and management, selling assets to repay debt, buy in stock and, in some cases, doing selective developments. Real estate markets are, by and large, healthy today, with only hotels and some health care properties hurting a bit, and new supply is being readily absorbed while occupancy rates are holding firm.
There is clearly loads of value in these stocks today. Whether you measure value by dividend yields, price to cash flow multiples, discounts to estimated net asset values, spreads over the 10-year T-note, whatever, these are very cheap stocks. Today, of course, no one cares; they've lost credibility with investors, and their attributes are very much out of favor in this go-go investment climate. I have no idea when the stocks will turn around in the short term, but have no doubt that anyone with the patience of a 2-3 year time horizon will do very well with these beaten up creatures. But they are clearly investments for those who don't mind marching to their own drummer. Lemmings need not apply.