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Real Estate & REITs
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July 11, 2003 REITWEEK Available

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By Reitnut
July 15, 2003

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Ken, thanks for mentioning last Friday's issue of REITWEEK. The following will be a rather long post, perhaps too long for a summer's day, but forewarned is forearmed!

Judging by the amount of posts on this board regarding the question of whether or not real estate and/or REITs are experiencing "bubble" pricing, the RW issue is, perhaps, timely. As I suggest in this issue, real estate and REIT investors are a conservative bunch, and hate buying into manias, or even overpriced merchandise. So it is natural and understandable for all of us to wonder whether today's REIT pricing is too good to last. Indeed, the total returns those of us who bought REIT shares a year or two ago have achieved are almost embarrassing. It is also natural for conservative investors such as ourselves to want to take profits.

And the bears have reason to be polishing their claws; there are some things to worry about in Reitdom, including the enthusiasm with which some investors are embracing yields. Some of the bear case is laid out in this issue of REITWEEK. Regarding REIT stock valuations, I am also a bit concerned. Ron's excellent post provided a lot of great insight on NAVs [Net Asset Value] and how they're calculated, and I very much agree with his points.

Anyway, if we use the firm that I think spends the most time on NAVs, and arguably calculates them better than most (Green Street), the average REIT stock is now trading at an NAV premium in excess of 10%. Is this cause to panic? Absolutely not. But are REIT shares pricey? Perhaps so. But even if one accepts that REIT stocks are a bit pricey, that's not necessarily a reason to sell them out. Dollar cost averaging for new investors would seem to be a pretty good strategy at the present time.

REITWEEK also explores another side of this valuation conundrum, which involves the long-term demand for real estate assets. I believe that Jim suggested in one of his posts that REIT valuations have seemed to grow into new NAV estimates, as cap rates have continued to decline. I am not trying to make the argument that cap rates will continue to fall, particularly if interest rates spike upwards in the months ahead, but if -- a very big IF -- real estate (and REITs) are under-owned assets, well, perhaps temporary sell-offs will be met with fresh buying by those who want to increase their allocations to real estate. Most financial planners who I've met and spoken with feel that they are keeping up with the latest thinking by placing 10% of their clients' assets in REITs. But maybe the number ought to be 15%. Or 20%. That would amount to a very substantial incremental demand for REIT stocks.

Certainly employees with 401k plans are under-invested in REITs, and a good argument can, I think, be made that most pension and endowment funds are under-invested in real estate, some of whom may use REITs as real estate proxies. This could be due to limited capital appreciation prospects for equities going forward (notwithstanding the big Equity Rally this year), coupled with high multiples and interest rates that may rise in the future, forcing P/E ratios (and equity returns) lower. It may also be due to low yields on investment grade bonds (and even junk bonds) and the need for much greater investment cash flows to fund retirement obligations of the baby-boomers commencing in a relatively short period of time.

Of course, as Jim mentions (rightly), should lots of this new demand for real estate assets materialize, much of it will be met with new developments rather than rising P/AFFO ratios for REIT shares. However, if the economic recovery isn't robust, some developments may not get done due to the difficulty of pre-leasing to committed tenants. This would be particularly true in the office and retail sectors. And, of course, there are lots of obstacles to new developments in some markets where home-owners and city planning commissions aren't always willing to embrace new projects which may increase traffic congestion, burden existing schools, etc. But this is old ground that we've plowed previously.

It is a complicated subject, and REITWEEK makes no pretense of answering these riddles. But, hopefully, it will cause us to do a lot of thinking about the future valuations of real estate, secular cap rates, REIT portfolio allocations and all sorts of other stuff that cause our heads to spin.

Anyway, for what it's worth (very little, if anything), if I were a short-term trader, I'd look for signs of a reversal of momentum to lighten up on my REIT holdings. But I am not a trader or market timer. So, I continue to add to my holdings, even at these current prices, but also realizing that my total returns going forward are unlikely to be as good as I expected from those REIT investments I made some months ago. And, even though most of my personal holdings are REIT shares, I will continue to look for attractive non-REIT investments for diversification.

Ralph


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