CipherCPA asks <<Why has the Reit sector been down the past two years? The economy has been good and interest rates low.>>

Here are my thoughts, for what they're worth:

1. The market for REIT stocks was sizzling hot back in '96 and '97, as they delivered total returns of about 35% and 20%, respectively. Momentum investors jumped on board in '97, and the REITs and their investment bankers took this as a sign of strong acceptance of, and demand for, securitized real estate, and sold close to $50 billion in new REIT equity, substantially increasing the public float and increasing the size of the industry by 54% within just 18 months. Many of the brokerage firms formed unit investment trusts at the very end of the REIT bull market in early '98, which were chickens that would come home to roost in '99 (see below).

2. As a result, REIT stock prices rose to large NAV premiums and sold at fancy multiples, as investors were pricing these shares as if their double-digit FFO growth would continue for many more years. They were thus vulnerable in the event investor expectations would change. They did indeed change in 1998, as investors began to worry about overbuilding in some real estate markets due to an abundance of capital flowing into the industry (e.g., Ethan Penner, et al).

3. At the same time that investors were increasing their required returns on REIT stocks, the REITs themselves were having more trouble finding real estate opportunities that could deliver the returns demanded. This was due to equilibrious real estate markets and falling cap rates, while some REIT managements overpaid for real estate in order to deliver on promised acquisition volumes.

4. Investors began to realize this and the capital markets shut down for REITs by the spring of 1998; this had the effect of causing analysts to assume few further real estate acquisitions (the end of "positive-spread investing") and thus ratcheted down their forecasted FFO growth rates. Declining growth rates almost always mean skidding stock prices and lower multiples. While REITs are "real estate," they are also equities.

5. At the same time, some high-profile REIT managements were getting themselves into a heap of trouble. Patriot American (now Wyndham) expanded too rapidly, and let short-term debt build to unhealthy levels. Meditrust management wanted to own the world on the back of its paired-share structure, and bought limited service hotels whose RevPar growth was about to go negative, and paid a fortune for a bunch of golf courses. Crescent bought Station Casinos, then changed its mind, while increasing the dividend in a misguided effort to prop up the stock price. Several REITs refused to acknowlege reality, and sold stock "forward," which created a ticking time bomb which exploded months later when they had to pay the piper.

6. The mismatch of supply and demand for REIT shares, declining (though still respectable) growth rates and management miscues and poor judgment caused falling stock prices throughout 1998, and investors hate stocks which are declining, especially when they don't understand the industry all that well. Individual shareholders bailed, and liquidated their REIT mutual funds, which caused yet more selling. Institutional investors wondered whether REITs were "ready for prime time," questioning how REIT stocks could perform so poorly vs. directly-owned real estate. So they, too, reduced positions.

7. By the latter part of '99 and into '00, investors began to realize that real estate markets were NOT becoming overbuilt, and that most managements were finally beginning to "get it." Yet, the REITs' stocks continued to be shunned, as investors of all stripes were throwing funds at the techs and the nets, and all value stocks (including those with substantial and sustainable yields) were not only shunned but used as fodder to buy still more tech and net stocks.

8. And that's where we are today. FFO growth estimates have slowed from 12-13% a few years ago to 7-8% today (a normalized and sustainable pace), and the P/AFFO for the average REIT has fallen from 14x to 8.5x, and the average dividend yield has risen from 5.6% to 8.6% -- due to increasing dividends but much more to declining stock prices. Today the average REIT trades at a discount to estimated NAV of close to 20%.

Today we have the bizarre situation of strong companies like Simon, Chelsea and many others selling below their IPO prices, despite having done a generally good job of increasing cash flows and dividends, increasing organizational strength and obtaining good property diversification within their chosen sectors. It is true that REITs are more highly levered with debt and preferred stock than they were back in '96, and that should influence REIT pricing; however, most investors (including most rating agencies) do not regard today's leverage of about 50% as troublesome (though they don't want it to go higher).

But even when adjusted for the higher leverage, and given the stability of real estate markets today and the greater experience and better long-term strategies of managements, REIT stocks are, IMO, unduly depressed. However, we may have to await a return to value investing before these critters will move ahead and trade at more realistic valuations. (Sorry for such a long post to a short and simple question).

Ralph