Warning: This post is unduly long, especially for a Friday afternoon. It is my humble attempt to reply to the musings of SSB's Jon Litt, when he downgraded the entire REIT industry.I have read Jon Litt's e-mail downgrading REIT stocks; actually, I read it twice in an effort to understand it. First, let me say that I have a great deal of respect for Mr. Litt; indeed, he's a long-time REIT veteran, and would never have been hired as the top REIT guy at a huge firm such as Citibank (Solomon Smith Barney) unless he was a very bright guy. And I agree with a lot of what he writes over the course of any particular year.That said, I have trouble agreeing with the reasoning contained in his Sept 8 release. As I read his missive, he is essentially saying two things: (a) “By any measure the group is expensive;” and (b) the “catalyst” that will cause REIT stock prices to decline substantially (“we believe the REITs can suffer a sell off of 10-15% in the next 12 months”) will be a stronger economy. Thus, he says, “In an “End of the REIT Bull Market” economy, investors will be attracted to other sectors of the stock market that promise big total returns as a result of the strong economy.” Also, “Should the economy add jobs in excess of new supply, GDP will accelerate, interest rates will rise and unemployment will fall. Corporate America, being more sensitive to economic changes than real estate, may become the darling of the stock market as investors chase growth.” Here's how I would reply to Jon:Dear Jon…First, let me say that your timing was impeccable. REIT stocks had been on a tear, and were due for some “profit-taking” over the near term. We experienced that on Thursday, though the early REIT stock losses on Friday morning have been extinguished and the stocks closely slightly higher. Thus the bears couldn't even put together two down days. But let's get to the basic issues. First, as to valuations: a. You say, “One of the more alarming statistics is that the spread between the REIT dividend yield and the 10-year Treasury yields is now 93 basis points, well below the historical average of 128 basis points.” However, Merrill Lynch looks at the same spread and, in their weekly report issued today, it concluded that the spread is 110 bps vs. an average of 120 bps. That hardly looks “alarming” to me.b. You say, “REITs are trading at a 30% premium to their 10 year average FFO multiple.” This is probably true; perhaps it's even higher. You then remind us that, “Part of this premium can be explained by the concept of trading at peak values at the trough of the cycle,” but conclude, “however, we believe a recovery in earnings is more than priced in.” Jon, let me remind you that higher REIT FFO multiples are the result of many things, some of which are even more important than the fact that stocks tend to trade at high multiples of trough earnings. REIT shares have shown substantial correlations with estimated NAVs over the years, and higher NAV estimates for REIT stocks translate into higher trading multiples. All else being equal, would you pay the same multiple for a company that owns 10% cap rate assets as you would for another REIT that owns 7% cap rate assets? No, I don't think so. Low cap rate assets = higher multiples, all else equal. When we combine lower cap rates and accelerating FFO growth, I don't see today's higher REIT FFO multiples as particularly troubling – as long as cap rates and NAV premiums don't become excessive. Bottom line: I am not at all troubled by today's higher FFO multiples, provided that (a) cap rates don't spike higher, (b) prospects for faster FFO growth over the next 8 quarters remain intact, and (c) the directions of inflation and long-term interest rates remain trendless.c. You say, “REITs are trading at a 24% premium to net asset value using current cap rates.” Jon, I think you and your sell-side compatriots are using data that don't reflect today's private real estate markets. I refer you to Barry V's recent missives (“REIT Wrap”) concerning NAV estimates by sell-siders. With all due respect, you are in la-la land. Green Street's average NAV premium, which may still be too high, is about 8%, roughly equal to the average over the past 11 years. Now, Jon, you also say, “The current cap rate environment, or the first-year yield investors will earn on the REITs portfolio of real estate, is likely unsustainable if the ten-year treasury yield moves to 5.5-6.5%.” Well, yeah…of course. But I don't see any signs that the yield on the 10-year is marching upwards. Indeed, it's fallen substantially since its peak in the early spring, and the current yield is now down to 4.16%.d. You say, “Commercial real estate pricing is likely in a mild bubble, as we have been arguing for several years, largely a function of low interest rates,” and suggest that, “we believe they [investors] will be in for a rude surprise when interest rates move up sharply.” Taking the latter issue first, no asset class will be unaffected should interest rates move up sharply – not REITs, not equities, not bonds. So what? We're all exposed to that risk. And as for your “bubble,” theory, I think that's just goofy. Cap rates, as demonstrated by a recent Green Street report, have declined just slightly more than the decline in interest rates on the Baa long-term bond, and remain within the 7-9% band which has been holding for quite some time. There is no evidence of any “bubble,” except, perhaps, for single-family homes in some locations.e. You note, “Relative to the broad market, REIT earnings multiples have expanded 16% so far in 2004 while the multiple for the S&P 500 has contracted 6%,” and you suggest that this pricing relationship will reverse: “REITs now look expensive to the broad market as measured by multiple expansion.” Well, perhaps. However, consider that (a) REIT earnings growth is likely in an up trend, while growth appears to be decelerating for non-REIT stocks; (b) non-REIT stocks are hardly cheap, at 17x estimated earnings (20x trailing), so the broader market is hardly on the bargain table; and (c) long-term total returns have been comparable between REIT and non-REIT equities, so perhaps trading multiples for these asset classes should be similar, as they are today, rather than non-REIT stocks bearing higher multiples as has been the case in prior years. Heck, greater liquidity for REIT stocks, alone, should justify some long-term multiple expansion.Next, regarding your “catalyst.” I will cheerfully concede that non-REIT equities could certainly outperform REIT stocks in the event that GDP growth accelerates, interest rates rise and unemployment falls. Certainly the multiples on REIT stocks have been firmer than those of non-REIT equities in recent months, and investors might be justified in putting new money into non-REIT equities at the expense of REIT stocks. Thus there could be some “reversion to the mean.” However, I have a couple of problems with this line of reasoning as you pursue it: First, it is very unclear to Chairman Greenspan, let alone to this poor scrivener, that GDP growth is accelerating; indeed, all the signs (e.g., falling bond yields, disappointing employment growth, sagging consumer confidence, moderating retail sales growth, increasing auto inventories, slowing home sales, less-than-ebullient business investment, high oil and gas prices, etc) suggest continued moderation in the economic cycle. Indeed, the UCLA Anderson School of Management, which has historically been one of the most reliable economic forecasters, believes that growth going forward is slowing, suggesting that “In a best-case scenario, the current slow patch in the recovery holds for two years or so, when more robust capital spending should reduce recession risk. In the meantime, a consumer-led pull back could induce a recession within the next two years.” Hardly the stuff of rapid GDP growth.Second, you give short shrift to the strong possibility that real estate, as an asset class, is being repriced across America. That does not mean, of course, that we are in a “new era” of real estate pricing where all the old rules no longer apply. It might, however, mean that the relative value of commercial real estate in relationship to the values of bonds and other equities has, indeed, changed. The point here is that if money begins to flow more heavily into non-REIT stocks due to a stronger than expected economy, it doesn't necessarily mean that money will flow out of real estate and REIT stocks – after all, almost all businesses benefit from stronger economic growth, including REIT organizations. While rising interest rates would hurt, increasing demand for space should offset much of that – and faster earnings growth (and better dividend coverage) might provide some support for REIT stock prices. In other words, I don't see a repeat of 1998-1999 when hordes of “investors” deserted REIT stocks to play the Internets.Finally, while you recognize the longer-term forces that have propelled the renewed interest in real estate and REIT stocks, you then ignore them. Thus you acknowledge: “The REITs fat dividend of 5.1%;” “Aging baby boomers may be slowing their wild west mentality toward the stock market in exchange for more predictable income stream REITs offer…this point cannot be emphasized enough;” “Fundamentals are improving;” “Funds flow has been positive;” and “Broader investor interest in REITs has been a trend of the past several years as REITs have been added to the S&P 500 as well as numerous 401k plans.” Well said, Jon. But you seem to have given no weight to these ongoing, long-term factors in your decision recommending that investors “underweight” REIT stocks. That's too bad. It's often more important to see the forest than specific trees, particularly for investors with long-term time horizons. I would think that, in the current environment, a “market weighting” for REIT stocks would be more appropriate. My own conclusion is somewhat different from yours. It is, quite simply, as follows: REIT stocks are, possibly, slightly overvalued at the present time, but by no more than a few percentage points. And I am not even very confident about that statement. Interest in real estate, including REIT stocks, remains very high today, for some very good reasons, and not only those you mentioned. A modestly growing economy with fairly low inflation and moderate interest rates is the very best scenario for real estate investors. Absent some significant change in the economic picture – one that few of us are able to foresee – this interest in real estate – direct and securitized – is likely to continue. A sudden and unexpected rise in long-term interest rates, however, would likely impact the prices of virtually all equities. But, absent knowing where long-term interest rates are headed, REIT stocks are as likely to rise by 10-15% as to decline by that amount; in my opinion, however, both scenarios are unlikely. I suspect that REIT stocks will just back and fill through the balance of the year, buffeted by statistics on job growth, inflation and all sorts of other economic data as the economy muddles along, and by the actions of traders who like to scrape and claw for a few basis points of outperformance and by other serious investors who like to rebalance their portfolios from time to time. I think that now is a particularly good time to continue to dollar cost average into REIT stocks, and to maintain targeted allocations. Jon, we love you – but we must take the stock market forecasts of you and your fellow sell-siders with lots of grains of salt. Ralph
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