After a colossal run, REIT stocks have been sold off. Many now trade at deep discounts despite stable financial performance. Are they poised to recover, or is this a classic case of the value trap?
Last month, as Wall Street was melting down and the global stock markets were crashing, I gave my parents some investing advice: I told them to invest in U.S. real estate investment trusts (REITs).
Talk about the strength of one's convictions: I even phoned my parents' financial advisor to tell him, specifically, which REITs to buy. He prefers to remain nameless in this story, but I can tell you that he thought I was misguided — and maybe even a bit pushy. Forget about the weirdness of receiving an unsolicited call from his clients' child; the advisor was a little shocked that I would put my parents' money in an asset class that many, including him, think will see more bad days ahead. His response was something along the lines of, “That's insane.” (For the author's picks, see table below.)
Look, I know I am just a journalist. Nonetheless, I do specialize in real estate writing, and I do not cheerlead or attempt to pump up any company or its securities. It's just that REITs are one of the best investments out there, in my humble opinion. REITs are attractive for both income (dividends are juicy — some say too juicy) and price appreciation. I love the opportunity REITs offer today, and there are a lot of smart analysts who agree with me. That said, it takes an especially strong stomach, and the risks are plenty. But if you've got three or five years, you should be bargain hunting.
“It's very rare that we have these valuation hiccups, where investors can get in with very attractive dividend yields,” says Ralph Block, a long-time REIT investor and publisher of the Essential REIT.
When 70 Cents Buys One Dollar Of Assets
Here's some background: REITs own approximately $600 billion of commercial real estate assets, or 10 percent to 15 percent of total institutionally owned commercial real estate, according to the National Association of Real Estate Investment Trusts (NAREIT). There are 146 REITs in the FTSE NAREIT All REIT Index, and 125 REITs are traded on the NYSE. In total, equity REITs have a market cap of nearly $300 billion.
Most REITs own one of the five main types of commercial real estate: office, retail, industrial, multifamily and hotels. But there are a number of specialty REITs that own movie theaters, vineyards, self-storage, student housing and timber. In the past, there have been REITs focused on golf courses, prisons and even parking structures.
And what a run they've had. They have, on average, outperformed the major indices for decades. Since 1983, U.S. equity REITs have only had five years of negative total returns against 18 years of double-digit total returns, according to NAREIT. Even more impressively, they achieved total annual returns in excess of 30 percent six times over the past 25 years.
REIT stock prices have dropped to levels not seen before in this decade. On average, they're off by 50 percent from their peak in early 2007. The entire REIT universe on October 17 was trading at a 34.6 percent discount to net asset value (NAV), according to SNL Financial. Regional malls have been hit the worst, and were trading at nearly a 62 percent discount to NAV. Even health care REITs and self-storage REITS — the top performers in 2007 — were trading at discounts of 10.3 percent and 25 percent, respectively. (See sidebar on page 61 for more discussion on NAV.)
“Given the discount REITs are trading at related to NAV, investors are buying a dollar's worth of real estate for 70 to 80 cents on the dollar,” says Rod Petrik, a REIT analyst with Stifel Nicolaus.
Another key metric — the price-to-FFO (funds from operations) multiple — suggests that REIT shares are priced inexpensively. The price-to-FFO multiple as of October 17 was 11.6, clearly on the low end of its historic multiple range (8x to 20x). Currently, the REIT sectors with highest multiples are health care, apartment and student housing. (Of course, critics argue that projected earnings, or FFO, will plummet as the economy takes a dive, driving the P/FFO multiple into the stratosphere; it is then you should buy, they argue.)
Worried About Your Fundamentals
REITs are clearly suffering from the same fear and panic that surrounds the rather ugly outlook for the U.S. economy in 2009. Many investors and analysts are worried that REITs will be among the hardest hit sectors as the economy worsens.
It's a legitimate concern, of course. Over the past several years, REITs have benefited from a kind of economic nirvana: strong economic conditions, low interest rates and access to cheap capital. But the economic climate is entirely different today. “The tailwinds of the past few years are becoming headwinds,” says Joel Bloomer, senior equity analyst with Morningstar.
For example, consumer spending has dropped significantly, and a number of retailers have announced bankruptcies. As a result, regional mall and shopping center REITs, as a group, have taken a hit on their stock prices, despite the fact that many REITs have long-term leases with retailers and vacancy rates continue to be low.
There are similar concerns for the office, hotel, industrial and multifamily sectors. As the economy continues to slog through its decline, more job cuts and higher unemployment is expected — something that is anticipated to dampen demand for office space. Office REITs with exposure to the financial sector and the mortgage industry — New York and Southern California — are expected to experience erosion in occupancy and net operating income (NOI).
Meanwhile, business and leisure travel has dropped off, creating a more difficult climate for hotel REITs; U.S. imports from Europe and Asia are down, making the outlook for industrial REITs somewhat dim. And, finally, during economic downturns, “house hold creation” (as it's called) stalls and some people even double up in apartments. That means multifamily REITs will likely see higher vacancies and decreasing rents.
That, in a nutshell, is the bad news. And, yes, I agree, fundamentals will weaken. But investors shouldn't be scared off. “Even though fundamentals have been in better shape and may weaken in certain sectors, we think there's a very strong buying opportunity for REIT investors,” says Jay Leupp, portfolio manager of the Grubb & Ellis AGA Realty Income Fund.
Some argue that many REITs may suffer in the near term, but will certainly deliver impressive results over the long run. “Any investor with a time horizon of more than a year is likely to benefit substantially as the economy recovers, and in the meantime the income characteristics should hold up,” says Paul Adornato, a REIT analyst with BMO Capital Markets.
You only have to look at the high dividend yield to see that REITs are considered dogs. Overall, U.S. equity REITs were yielding 6.87 percent recently, according to SNL Financial. Roughly 32 percent of U.S. equity REITs are currently offering double-digit dividend yields, based on SNL Financial's evaluation of 120 REITs. (See table on page 59.)
“With REIT stocks getting pounded, dividend yields are obscenely high,” says Rich Moore, a managing director with RBC Capital Markets' REIT group. “Typically, when you see a 25 percent yield, you'd think that the company has a problem. But business for most REITs is good enough to pay those yields.”
In fact, Adornato notes that the REIT industry has very solid dividend coverage, with only an 80 percent payout on its AFFO (adjusted funds from operations, a common metric for REIT performance). “That's a pretty healthy cushion,” he says.
So far, only one REIT — General Growth Properties Inc. (NYSE: GGP) — has cut its dividend. The Chicago-based mall REIT is burdened by billions of dollars of debt, and the dividend cut has less to do with the company's financial performance and more to do with its weak balance sheet.
Dividend cuts are always a concern, of course, especially for highly leveraged REITs if they are forced to refinance their existing debt at much more expensive interest rates. That's why it's important that investors make their REIT picks based on more than a low stock price.
Greg Sukenik, equity research analyst for REITs at Zacks Investment Research, says the biggest mistake an investor could make right now is to invest in REIT stocks just because of their valuation. “I wouldn't chase the cheapest ones,” he advises. “I'd stick to the REITs that will be able to withstand a downturn.”
The REITs that are most likely to weather this economic storm are those with strong balance sheets and manageable debt. Dionisio Meneses, portfolio managers of the Schwab Global Real Estate Fund, contends that most REITs have carefully managed their debt levels for the past two decades. “REITs learned in the 1980s that leverage is their Achilles Heel,” he says, pointing out that on average, REITs have a debt-to-capitalization ratio of 50 percent or less.
Moreover, Jack Foster, head of global real estate research for Franklin Templeton Investments, believes that banks and other lenders will be more interested in capitalizing on REITs than other real estate players. “If you have companies that have spread the maturity rates over five to seven years, they are going to be attractive to lenders,” he explains. In fact, he believes that REITs will be able to boost their earnings by closing a number of accretive acquisitions.
ON SALE: JENNIFER'S REIT PICKS FOR HER PARENTS.
According to real estate reporter Jennifer Popovec, these REITs have strong businesses, yet trade for less than the value of their underlying assets.
|Company Name (Ticker)||YTD Total Return||Dividend||Price to NAV||Debt-to-market cap ratio||FFO Multiple|
|AvalonBay Communities (AVB )||-18.26||4.77||68.07%||33.04||17.7|
|Bio-Med Realty Trust (BMR)||-15.03||7.08||67.82||41.98||13.1|
|Corporate Office Properties Trust (OFC)||-7.70||5.28||73.09||47.07||14.1|
|Extra Space Storage(EXR)||-14.71||8.61||65.48||49.06||14.8|
|Simon Property Group (SPG)||-21.31||5.42||66.37||40.16||15.1|
5 REITs with lowest debt to market capitalization.
|Company Name (ticker)||Debt-to-market cap ratio||Total return (YTD 10.16.08)|
|National Health Investors (NHI)||0.98||6.13|
|PS Business Parks (PSB)||2.61||-10.22|
|Public Storage (PSA)||3.81||6.97|
|LTC Properties (LTC)||4.54||-4.18|
|USA REIT (USR)||9.02||-32.03|
|Source: SNL Financial|
5 REITs with the highest dividend yield.
|Company Name (ticker)||Dividend (2Q08)||Total return (YTD 10.16.08)|
|Ashford Hospitality (AHT)||35.90||-62.99|
|Glimcher Realty Trust (GMT)||24.38||-60.02|
|CBL & Associates Properties (CBL)||23.09||-57.62|
|Pennsylvania REIT (PEI)||21.49||-61.59|
|HRPT Property Trust (HRP)||21.16||-44.02|
|Source: SNL Financial|
WHAT'S A COMMERCIAL PROPERTY WORTH?
Talk about mark-to-market accounting. REIT stock valuations are determined by the net value of the assets the REIT owns — obvious, right? But now some argue that the true value of real estate assets (NAV) in today's market cannot be accurately calculated because of the lack of property sales over the past 12 months. In fact, according to Real Capital Analytics, investment sales activity in the commercial property sector is down by as much as 70 percent year-to-date.
“In light of the limited number of transactions in the marketplace, there's less confidence in NAV than there has been in the past,” says Rod Petrik, a REIT analyst with Stifel Nicolaus. “No one questions that real estate values are coming down and cap rates are going up, but you don't have the transactions to prove how little or how much.”
That's why Petrik has modified his NAVs to be based off of capitalization rates that have increased 100 basis points. (Cap rate is determined by dividing the property's net operating income by its purchase price; an increase in cap rates means a higher return, and cap rate compression means a lower return. Also related to cap rates and NAV, current cap rates illustrate market demand and pricing conditions, therefore, an increase in cap rate means that pricing and value have decreased.) Even then, the calculations indicate that stock prices have baked in an overly pessimistic expectation of real estate price declines, he says.
Meanwhile, a number of experts have blown off criticisms related to NAV, pointing to the fact that NAV rarely exceeds replacement costs. “We're not talking about dot coms here — we're talking about companies that own properties that are worth millions of dollars,” says Peter Miralles, president of the boutique financial planning firm Atlanta Wealth Consultants. “You can do the math to figure out how much it costs to develop a similar asset today. In most cases, it's more than what properties would sell for on the market.”