There They Go Again
Board: Real Estate Inv. Trusts: REITs

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By Reitnut
March 5, 2007

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"There They Go Again"

Barron's has had a bearish bias against REIT stocks ever since I began to peruse that publication way back in the late 1960s. They might, on occasion, interview a well-known REIT analyst or investor such as Bob Frank, Mike Kirby or Marty Cohen but, for the most part, their staff writers, who wouldn't know a cap rate from an interest rate, have done hatchet jobs on the REIT industry. These bearish articles have, for the most part, not only been poorly-reasoned but also just plain wrong. Yet, like a bad gambler, they don't know when to cut their losses.

As we cannot know what will happen to the price of any stock or group of stocks over the short term, the negative article appearing in this week's Barron's, which specifically trashes Avalon Communities (AVB), could possibly prove to be timely. A broken clock will be right twice a day. More likely, the stock gets trashed on Monday, then closes the week higher.

The bearish article acknowledges, of course, that AVB is the best apartment REIT in the industry. Their effort, however, is intended to show that, notwithstanding the quality of this company, its track record and its value-creating abilities, the stock is grossly overpriced - as is, they argue, the entire REIT industry. They may, with hindsight, be proven right; however, their argument is heavily dependent upon a significant increase in commercial real estate cap rates, which writer Doherty spends little time investigating. Let's take a walk through some of the arguments made by Ms. Doherty in the article.

At that lofty level, however, the good news and then some may be reflected in Avalon's shares. Based on a multiple of funds from operations, the industry's preferred metric, the company is among the most expensive names in one of the most expensive stock-market sectors. "AvalonBay is the go-go stock within the go-go REIT sector," says Doug Kass, head of Seabreeze Partners, a hedge fund that has sold short the stock. "Once the momentum comes out of this sector, a lot of investors are going to be heading for the exit at the same time." He sees the stock falling to 110 a share.

Perennial REIT short-seller Doug Kass is always good for some bearish quotes, and Barron's is always willing to accommodate him. But they never include a track record of his REIT shorts; doing so would likely prove that Mr. Kass has been much more often wrong than right about REITs. The comment is also way off base, in that it suggests that REIT stocks should be valued on the basis of FFO multiples; more on this metric below. The rest of the quote, including the $110 target, is just hyperbole. Where did Mr. Kass get that number? Did it just spring, like Eve, out of his rib - or some other place?

Individual investors also have fallen in love with REITs. According to Financial Research Corp., REIT mutual funds have almost $78 billion in investment assets today, up from $9 billion in 1999, when the sector suffered its second straight year of outflows as investors turned their attention to tech.

"Fallen in love?" Ms. Doherty seems to enjoy using emotion-packed phrases as a weapon in attempting to prove her case. She is suggesting that investors have embraced REIT stocks as they did techs and dotcoms in the late '90s, which of course could mean a clear overvaluation and imminent collapse. However, she cites almost no statistics to support this so-called "love affair" with REIT stocks, and comparing current mutual fund cash flows to those at the end of a 2-year horrendous REIT bear market proves nothing. In fact, I would venture to guess that most individual investors have well below 10% of their assets in the REIT asset class; that's more like friendship than a "love affair."

Investors typically value REITs on the basis of funds from operations because that measure adds depreciation to earnings. AvalonBay currently trades for 27 times 2007 estimated funds from operations of $4.83 a share.

Perhaps some investors value REIT stocks on the basis of FFO, but that is a poor way to value them. REITs are best valued on the basis of appropriate premiums to, or discounts from, estimated NAVs, and Green Street Advisors has shown that the correlation is very high between a REIT's NAV growth and its stock price. As we all know (except, apparently, Ms. Doherty), REITs that own assets in low cap rate markets will obviously see their shares sell at higher FFO multiples, reflecting these lower cap rate assets - which have greater insulation from excess supply and better long-term growth profiles.

Thus investors are willing to pay more for each dollar of cash flow generated by these more desirable assets. All else equal, AVB will sell at a higher FFO multiple than UDR, as the blended cap rate of AVB's assets is 4.5%, while UDR's is 5.9%. That doesn't mean that AVB's stock is more "expensive" than UDR's.

That multiple is close to twice the growth in FFO, almost twice the price-earnings multiple on the S&P 500 and double the industry's historic average. If the price-to-FFO ratio were to return to its historic range, the shares would be 50% lower.

A fair point, but Ms. Doherty doesn't develop it properly. In suggesting that the average FFO multiple in Reitdom might revert back to historical levels, she is obviously taking the "cyclical" rather than "secular" side of the commercial real estate pricing debate. I - and many others - have written often about why the repricing of commercial real estate over the past few years is largely secular in nature, not cyclical, and so far we have been right -- commercial real estate pricing has been maintained despite rising interest rates, bearish opinion and a strong stock market.

And institutional capital just keeps flowing. The "cyclicalists" may yet be right, but Ms. Doherty doesn't even broach the subject of this all-important debate.

It is also below the 4.5% yield on 10-year Treasury bonds, and isn't much higher than the 1.8% dividend yield on the S&P 500. Among S&P components, General Electric (GE) yields 3.2%, Bank of America (BAC) 4.4% and Pfizer (PFE) 4.6%.

This is another of the bears' perpetual arguments. Of course, to some extent, REITs and commercial real estate compete against equities (and, of course, bonds) for available capital. So far, they have been able to compete quite well, despite the frequent (and numerous) allegations we've heard for a long time that REIT stocks are "overpriced" vs. stocks (and bonds). As Green Street acknowledges, "Despite consistent 'hot' readings over the past four years [in our valuation metric comparing REITs with other equities], REITs have continued to pace the market."

So are REIT stocks even more expensive today? Or were they simply too cheap in prior years? The longer cap rates remain at current levels, the more it will appear that they are appropriate rather than signs of irrational exuberance. If so, it wouldn't be surprising to see quality REIT stocks trade at higher multiples than S&P stocks on a regular basis. Besides, we don't learn much when comparing REIT multiples to S&P earnings multiples; they are very different animals, as are their risk profiles.

Granted, Avalon Bay has a long history of confounding skeptics. Its shares were considered rich at the start of 2006, but they subsequently rallied 50%. Likewise, they were deemed overvalued in 2005 -- before climbing 23%.

And just who deemed AVB shares "rich" and "overvalued" in the past? Well, none other than Doug Kass and the Barron's writers. Why should we believe them now? Shouldn't we give at least as much credence to those who have been right?

Table: Is The REIT Party Over?

"REIT party?" As in, "these REIT investors are all just drunken revelers, and are certain to suffer a major hangover in a few hours." This is what that caption suggests. I would argue that a better analogy for today's REIT investor would be an enjoyable weekend with friends at a mountain resort, where large and satisfying meals have been served, along with some excellent wine. Then, time to go home and regroup for another week at the office. REIT stocks are more likely to be flat for the rest of the year than to decline precipitously, and could yet rally if cap rates stabilize at current levels and the US economy muddles along at 2-3% GDP growth.

"Multifamily fundamentals are starting to decelerate and that's not reflected in the stock," argues John Stewart, a Credit Suisse analyst who has a Underperform recommendation on the stock...."Condos are coming into the apartment market, and combined with slowing economic activity, apartment companies may miss their expected 5% to 7% rental-increase assumptions," says Kass. "If that happens, funds from operations would come in below expectations."

First, John Stewart may be a smart guy, but Ms. Doherty has provided no evidence whatever of his acumen in making good calls on REIT stocks. Besides that, he's just plain wrong about decelerating fundamentals not being reflected in the prices of apartment REITs; these stocks have underperformed the REIT industry since the end of the third quarter of 2006. Says a Green Street Advisors report as of February 15, "Apartments have underperformed the NAREIT Equity Index by roughly 900 basis points since the beginning of October, including 400 bps of year-to-date performance."

I would argue that this "deceleration" is already reflected in today's prices. Besides, the "deceleration" is coming from very high levels of growth, which most REIT investors know cannot be sustained for long periods of time. SS NOI growth will still be very strong this year and for most of next year (about 6.5% this year and 6.0% in '08), and then will slowly drift down to more sustainable levels. Commercial real estate and most REIT investors know this, all of which is reflected in today's apartment cap rates.

These cap rates, in turn, are reflected in today's REIT stock prices, less a discount, i.e., the apartment stocks are generally trading at discounts to estimated NAVs, which suggests that stock market investors are building in a cushion against possible rises in cap rates. AVB's estimated NAV is $136.50 (per G/S), while the stock closed at $131.29, a discount of 3.8%. We should keep in mind, however, that NAVs are based not only on prevailing cap rates, but also forward-looking NOI growth, which will be strong for some time (barring a recession). Thus NAVs could remain steady, or even rise, even in the face of gently rising cap rates.

Messrs. Kass and Stewart may, of course, be proven right in their bearish prophecies. However, the bear case depends upon either a very weak economy, which would force weaker NOI growth for apartment owners (and, by the way, trash the prices of other equities also), or a significant increase in the cap rates or IRRs that institutional investors are looking for. So far, unless last week's market break was a harbinger (which I doubt), there are no signs of either.

Property & Portfolio Research estimates additions to the market will return to historic levels in coming years; in 2011 additions could rise as high as 219,557. The firm forecasts vacancy rates returning to 6.2% by 2011, and rent growth falling to 2%. If these forecasts are on target, they are not factored into the shares of AvalonBay -- or any other apartment REIT, for that matter.

219,557 units, huh? 6.2% vacancy rates by 2011? I am duly impressed by such mathematical precision. However, maybe if a few assumptions are tweaked a bit, the right number is 167,213 new additions and a 4.67% vacancy rate. Macro pundits cannot even reliably predict supply or vacancy rates beyond the next 12-18 months, let alone at the end of the next four years. This is because apartment market conditions are so dependent upon large-scale variables such as job growth, household formation, interest rates, rental rates, home prices and such, and can vary widely by market. GIGO.

Suffice it to say that those who invest in apartments and apartment REITs are assuming, by default, that by 2011 market conditions will generally be similar to what they've been like for most of the past 20 years - not hot, not cold. Accordingly, I strongly take issue with the claim that apartment REIT investors expect spectacular growth out to 2011.

Between 8% and 9% as recently as 2001, the cap rate has declined to 4.9% for REITs in general, and 4.0% for AvalonBay, Credit Suisse's Stewart calculates.

See above regarding the debate between the cyclicalists and the secularists. Stewart is obviously in the former camp. If so, he's been wrong for the past four years. Besides, his cap rate calculation is wrong.

The pipeline could add $40 to $50 a share in net asset value, he says, helping to close the gap between the REIT's outsized market value and its NAV.

What gap? As of Friday's close, the "gap" was negative, with AVB's stock trading below its current NAV. And "outsized" market value? Shame on you, Ms. Doherty, for assuming facts not in evidence.

That said, after five-plus years of a bull market in real estate, property values -- and thus, NAVs -- are likely inflated.

What do you mean, Ms. Doherty, by the term "inflated?" Higher than prior values? Sure, for good reason; commercial real estate is generating strong rental and NOI growth, supply is moderate in most markets, and sophisticated buyers are underwriting some pretty decent NOI growth over the next few years. Commercial real estate is viewed as a desirable - and worthy - means of portfolio diversification, so why shouldn't real estate values be higher today than several years ago? So, if "inflated" means "higher," I would readily agree. But if you mean, like in a bubble, then you are again assuming facts not in evidence.

Avalon deserves its gold-star reputation. But that won't prevent investors from seeking shelter elsewhere if industry fundamentals weaken.

Well, yeah. But doesn't that caveat apply to all stocks in all industries? Won't the prices of oil stocks, or consumer stocks, or insurance stocks decline "if [their] industry fundamentals weaken?" Ms. Doherty has closed a very weak article on a very weak and unpersuasive note.


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