Real Estate Inv. Trusts: REITs
Re: Reits on the Mish board

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By Reitnut
October 17, 2006

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I am very late to this "thread," for which I apologize. The discussion has been, at times, heated, but I think some very good points were made by both sides of the debate. So, although it's certainly not needed, let me add my own take on the REIT quandary, for what it might be worth. Warning: This is a rather long post, so prepare to be bored!

First, I think there is no question at all that, on any metric other than NAV premiums, REIT stocks are trading at expensive levels when compared with how they've traded historically -- vs. other stocks and the great wide world of bonds. It is for this reason that Green Street has concluded that its "thermometer" is very hot in all respects except for REITs' valuations vs. commercial real estate. And, the only reason why REIT stocks are not "overheated" vis-�-vis commercial real estate is that the latter is trading at historically low cap rates. These low cap rates translate into correspondingly high P/FFO or P/AFFO multiples (and low dividend yields) on REIT stock prices.

Now, Green Street's Mike Kirby has acknowledged, in "Heard on the Beach" and in my own discussions with him, that the firm's "thermometer" is based upon historical metrics. As REIT stocks have never traded at higher valuations vs. stocks and bonds than is the case today, naturally the firm's thermometer is at a dangerously high level.

But how valuable are historical valuation relationships as a predictor of future investment performance? Of course, investors have, everywhere and at almost all times, been burned by "it's different this time" theories, and thus intelligent investors will look at historical relationships and deduce from them that any asset class or sector of stocks that have outperformed for a long period of time will "revert to the mean." And REITs may, indeed, do that very thing. Those who believe that historical relationships and metrics are iron laws that are never broken will have long ago sold all their REIT stocks. But are they right?

Perhaps. However, another precept, not limited to the investment world, is that one should never drive forward by looking exclusively in the rear-view mirror. And sometimes the world of investing does witness significant long-term changes in relative valuations among asset classes. Some years ago equities never traded at dividend yields that were lower than bond yields; that "iron law" has been broken, and may be broken forever. And investment veterans have been surprised indeed that drug stocks are trading at P/E ratios well below that of the broader market; this situation may continue for some time.

So we should go beyond historical parameters and ask ourselves: (a) whether the historical relationships between REIT stocks and equities and bond yields were "correct" (or whether REITs (and commercial real estate)) have been systematically mispriced for many years in the past; and/or (b) whether there is something in the current global or domestic economic or financial environment that justifies commercial real estate (or REIT stocks) being priced at higher levels relative to other asset classes than has been the case historically.

I don't know the answer to either of these questions, but have thought a lot about them. As for the first, I think there is a good argument that can be made for the premise that commercial real estate has been inefficiently priced vs. bonds and equities in prior years. This has to do with the prior illiquidity of both, the lack of transparency, and the enthusiasm with which equities have been regarded by both individuals and institutions -- which have pushed P/E multiples ever higher, culminating in the market blow-off in 2000 (though P/Es, while still relatively high, are lower than they were back then).

And yet, according to both NCREIT and NAREIT statistics, most quality commercial real estate has generated, unlevered, returns very similar to those of equities, i.e., about 9-10%, and much better than bonds -- with modest volatility and risk. Why should commercial real estate/REITs have been priced so cheaply, given their investment characteristics? Perhaps for both real and perceptual reasons that no longer apply. Perhaps those of us who have owned REIT stocks for the past few years have simply been the beneficiaries of this massive repricing towards a new reality in the relative pricing of asset classes.

The second part of the quandary is whether there is something different at work today that makes commercial real estate and REIT stocks worth higher valuations relative to bonds and equities than has been the case in the past? This is a tougher call, IMO. Certainly the desire for investment diversification has rarely been higher than it is today. If one can obtain more diversification via an asset class that is relatively predictable and with a good long track record, perhaps that alone should be enough to enable it to trade at higher than historical valuations.

A second reason may be the nature of today's competitive landscape. Once predictable drug companies can no longer boast steady and predictable drug pipelines, with high earnings visibility, and their plight is prevalent among virtually all public companies today. The good news is that state-encrusted economies are in retreat everywhere but the Middle East; the bad news is that companies everywhere, from China to South America, are able to produce competitive products, with lower labor costs. And technology is more widely available; China will soon be competitive with technology as well as cheap labor. To paraphrase Nixon's comment about all of us being Keynesians, perhaps today we are all capitalists. This is taking its toll on the risk-reward trade-offs involved in owning equities.

Perhaps this phenomenon can also be seen in the yields of utilities and pipelines; they are abnormally low. Could this be due not only to low interest rates, but also to the predictability of their income streams?

Perhaps a third reason might be the incredible volatility in the world of equities, perhaps driven by hedge funds and other short-term investors. A modestly lower guidance by management for the following year, not to mention a dreaded "earnings miss," can crater a stock by over 8% in a single trading day. Of course, our own world of REITs is more volatile also (see the price performance of HST following what was a pretty solid earnings report but which nevertheless disappointed some). But the stability and predictability of REITs' cash flows would argue for a higher valuation vs. equities.

I would add that the prospects for most commercial real estate are unusually healthy these days. There is little oversupply, occupancy rates are rising and landlords have pricing power. As both growth prospects and risk levels affect cap rates (and REIT P/AFFO multiples), it would be surprising if cap rates were not lower and P/AFFO multiples higher than during most periods of the commercial real estate cycle. This, of course, will change as we progress through the cycle, but there is perhaps one more year of unusually low caps and high multiples.

A final point. With the US economy slowing (most expect GDP to hover between 2% and 2.5% over the next few quarters), commercial real estate is a particularly attractive place to put capital to work. I have written about this in Essential REITs past, and believe that stable and predictable cash flows should be more highly valued in a slow-growth scenario where interest rates and inflation remain low.

OK, I will be merciful and put this post to bed. To sum up, there is no question that REIT stocks (and their big brother, commercial real estate) are trading at scary -- and historically high -- prices. Some of this may be explained by inefficient pricing in the past, and some may be justified by their current investment attributes (and investors' thirst for greater diversification).

That said, commercial real estate (and its derivative, REIT stocks) isn't cheap on any metric, and the best that we can reasonably expect, assuming no "reversion to the [historical] mean", is returns of 7-9% going forward, should cap rates and P/AFFO ratios remain stable and value is created via steady internal NOI and NAV growth, along with some external growth opportunities.

Although I don't much practice it myself, I think the watchword continues to be DIVERSIFICATION. We will never know when an asset class begins to perform in a manner very different from what we expect.


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