REIT stocks, ETFs, and Mutual Funds are in the Danger Zone this week. Historically low interest rates over the past few years have caused the valuations of REITs to rise faster than the overall market, outstripping the S&P 500 for the last four years and reaching valuations not seen since the peak of the real estate bubble in 2007. Yield seeking investors, unable to find value in traditional yield investments like bonds, have flocked to the high dividends offered by REITs.
The result of this influx of investors has been REIT valuations getting ahead of the fundamentals. Vanguard REIT Index Fund Institutional Shares (VGSNX), the largest REIT fund by assets, saw its valuation increase by 268% between its low-point on March 6, 2009 and its most recent peak on May 20 of this year. Its peak price of over $17/share hadn’t been seen since early 2007 when it reached ~$18.70. Unfortunately, yield investors have seemingly ignored the increasingly dangerous valuation of their investments and the risk to their principal capital.
Interest rates won’t stay low forever, and REIT prices have been hit hard in recent weeks over speculation that the Fed is considering raising rates in the near future. Bond yields have risen as a result of this talk of tapering. Investors are starting to get out of REITs, which has driven down the price of VGSNX by 12% since May 20.
Even with this recent price drop, the current valuations of REITs are unsupported by their fundamentals. The ratio of price to economic book value (the perpetuity value of a company assuming zero growth in after tax profit, or NOPAT) is a good indicator of whether a stock is over- or under-valued based on current cash flows. The average price to economic book value of the top 10 REITs by market cap (excluding two with negative EBVs) is an extremely high 4.6. By comparison, the S&P 500 (SPY) has an average price to EBV of 1.9. REITs are not exactly high-growth businesses to begin with; so such lofty cash flow expectations are a major red flag.
The Difference Between REITs and Utilities
Some investors might be wondering why REITs and not Utilities are in the Danger Zone right now. After all, Utilities have seen a similar influx of yield seeking investors driving up prices, and I ranked the Utilities sector second to last in my most recent Sector Rankings Report.
The difference between the two asset classes comes down to the magnitude of their overvaluations. As Figure 1 shows, REIT and Utilities funds have shown a remarkable correlation since early 2009. The difference is that VGSNX and VNQ have more than tripled the returns of the largest Utilities ETF (XLU) and mutual fund (FRURX) over that time period.
A look at the fundamentals bears out the proposition that Utilities are not as dangerously valued. The top ten Utilities by market cap have an average price to EBV of 1.6, even lower than the S&P 500 (This is not to say that I like Utilities. The top ten Utilities also have an average return on invested capital (ROIC) of under 4%).
Over the past few weeks, REITs and Utilities have both experienced significant market corrections. However, as Figure 1 shows, REITs have risen much higher, and therefore have much farther to fall, than Utilities.
Catalyst for a Reversion to the Mean
I’ve written about individual REITs in the past, specifically Ventas Inc (VTR), and argued that their high valuations meant a reversion to the mean was coming. I didn’t know back then what the catalyst would be for such a reversion, but I think we’re seeing it now.
Yield-seeking investors have driven up REIT prices for years now. As those investors head back to more traditional yield investments, I don’t see anything else to hold up these inflated valuations. There are very few REITs out there that can even approach justifying the expectations for future cash flow that their current prices imply.
Rising interest rates will also slow down the growth in real estate prices that drives expectations for future REIT profit growth. Opportunities for growth will still be present, but not enough to justify the sky-high valuations.
The Worst REIT stocks and funds
Oppenheimer Real Estate Fund (OREAX) is one of my least favorite REIT funds and earns my Very Dangerous rating. OREAX allocates over 82% of its value to Dangerous-or-worse rated stocks while less than 1% of its assets are rated Attractive-or-better. The stocks held by OREAX have an average price to economic book value ratio of 4.9. If this isn’t bad enough, OREAX also saddles investors with total annual costs of 4.08%. With such poor holdings and high costs, it astounds me that OREAX has been able to attract over $1.1 billion in assets.
Simon Property Group (SPG) is one of my least favorite stocks held by OREAX. SPG is the largest REIT by market cap and earns my Dangerous rating. As a company, SPG is actually not doing too poorly. It has positive and rising economic earnings and a middle-of-the pack ROIC of 8%.
Still, while SPG’s $23 billion in debt should concern investors, the stock’s valuation is the real red flag. A decent company can be a bad stock, and SPG is definitely a bad stock right now. Up a whopping 490% since March 2009, SPG is at a dangerously high valuation. To justify its current price of $154.58/share, SPG would need to grow NOPAT by 10% compounded annually for the next 14 years. Absent another real-estate bubble, that growth scenario seems unlikely.
SPG is the top holding in OREAX, which goes a long way towards explaining the fund’s poor rating. Overall, 209 out of the 210 REIT ETFs and mutual funds that I cover earn a Dangerous-or-worse rating. 175 of these earn a Very Dangerous rating.
Some Value Still Remains
Annaly Capital Management (NLY) is my top-rated REIT and makes my Most Attractive Stocks list for June. Unlike other REITs that have seen huge gains over the past four years, NLY’s price has already fallen below its March 2009 level. At its current valuation of ~$12.55/share, NLY has a price to economic book value ratio of 0.4, implying that its NOPAT will permanently decline by 60%. Given that NLY has grown NOPAT by an impressive 22% compounded annually over the past 10 years, such a dismal projection seems unwarranted. With most REITs being so overpriced, I’m surprised that NLY is available at such a steep discount.
Unsurprisingly, NLY is by far the top holding of iShares Mortgage REIT Capped ETF (REM), the one REIT fund to earn my Neutral rating. REM’s 21% allocation to NLY should help it outperform its many peers in the REIT fund universe.
Yield investors need to still be aware of the impact of appreciation and depreciation in the prices of their investments. Just looking at dividend yields without doing due diligence on a stock is a good way to lose a lot of money. Investors turning to REITs for the dividends need to make sure they’re finding the few gems in the sector, like NLY, rather than investing in dangerously expensive stocks like SPG.
Sam McBride and André Rouillard contributed to this report.
Disclosure: David Trainer, Sam McBride, and André Rouillard receive no compensation to write about any specific stock, sector, or theme