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Author: Reitnut Big red star, 1000 posts Top Favorite Fools Feste Award Nominee! Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 77107  
Subject: It's a Relative World Date: 3/10/2013 7:37 PM
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Posting prior blog posts that I have done for SNL Financial under "Block Party" seems to be well-received here, and SNL has offered no objection as long as they are sufficiently "stale." So, I will post another, done almost a month ago.

Ralph


Truth to tell, I get grumpier as I age. That admitted, there’s a lot to be grumpy about in today’s schizophrenic investment world, including the prevalence of self-appointed experts who issue market pronouncements without sufficient thought or reflection. Like my Golden Retrievers Riley and Kacie, who think it’s time for a walk whenever I open the side door, they are often wrong, but never in doubt.

The cause of a recent onset of grumpiness was reading an article by some guy claiming that REIT stocks are expensive because of their low dividend yields and high earnings multiples relative to those in prior years. But here’s the problem with such reasoning: Due to the recent globalization of markets wrought by the Internet age, all asset classes now compete with one another everywhere to attract capital.

Accordingly, we cannot make any rational assessment of the value of any asset class without looking at all of them, as well as global interest rate and macroeconomic environments, along with the full spectrum of risks that affect valuations.et me try to illustrate this. Suppose you are a Rip Van Winkle wannabe, and went to sleep for six years. Suppose you eventually wake to find the average equity REIT trading at a P/AFFO multiple of 13x and a dividend yield of 6%. Would you then shout “REITs are cheap!” and write a blog post for Seeking Alpha proclaiming your discovery? Not if you thought about things for more than a few seconds. You’d first want to enquire about the current health of the stock market, prevailing earnings multiples, interest rates, bond yields, commercial real estate markets, inflation, prospective GDP growth rates, the state of Europe and Asian economies, geopolitical risks, and even prevailing levels of risk aversion.

Suppose you then learned that most equities were selling at 7x next year’s earnings, inflation was running at a 5% annual rate, investment grade bonds were yielding 8%, real estate market cap rates were at 9% and most property markets were oversupplied with new product. That 13x AFFO multiple and 6% dividend yield suddenly doesn’t look so good, does it?

REIT shares are, today, trading at relatively high multiples and modest dividend yields – but they are doing so for very logical reasons. Inflation is limping along at 1.5%, interest rates are at historic lows (as are bond yields), and the stock market isn’t exactly cheap in the context of reduced earnings growth expectations, possibly peaking profit margins, and economies that are, in substantial part, propped up by money-printing by central bankers. Commercial real estate markets aren’t booming, but space is being leased, absorption is positive and, in some markets and sectors, rents are rising. New, competing development is subdued. Cap rates are appropriately low, and real property return spreads relative to Baa-rated bond yields are higher than normal. REIT shares are not trading at crazy NAV premiums. The bottom line? They are not expensive in this type of world. I worry about a lot of things, but excessive REIT stock valuation, in the context of all these variables, isn’t one of them.

But, of course, we can’t have it both ways. If we need to be concerned about all those factors and circumstances that guide us to appropriate valuations, we also need to realize that we live in an ever-changing world – today’s landscape may be very different tomorrow. Investors such as mutual fund portfolio managers, who are competing against their peers and their benchmarks on the basis of relative performance, have less reason to be concerned about the macro environment a couple of years out – or, at the least, they will be content if they feel they can spot changing trends as well as the next guy. But those investors looking for good absolute returns with modest risk do need to frequently consult crystal balls and chicken entrails.

Will interest rates or bond yields spike in the event that the bond vigilantes wake from their slumber and no longer deem the US creditworthy? Will the New Normal recovery get buried under the weight of higher taxes, government cutbacks and increasing regulation, resulting in another recession? Will global stock markets crash in the event of a new and serious flare-up in the Euro debt crisis, perhaps causing commercial real estate cap rates to levitate (as they did in 2008-2009), and in turn causing REIT NAVs to plummet? Indeed, can Europe – particularly Spain and Italy – really muddle through?

These are all issues that matter to the absolute return investor. However, when looking for absolute returns, the problem is this: Any seismic shifts that will significantly affect the future fair values of asset classes are quite difficult to forecast. And because of this difficulty, and the fact that nobody (particularly the self-anointed pundits) can consistently and reliably predict interest rates or recessions, most of us will not want to play the forecasting game – or, if we do play it, we won’t take ourselves too seriously. Accordingly, most sane investors must evaluate asset classes on the basis of what we know – or think we know – today. Putting it simply, today’s valuations must be made in the context of today’s world.

There are many who try to determine absolute values by poring over market history, looking for the “mean” to which all things supposedly revert, while claiming that it’s never “different this time.” I know how tempting it is to run historical numbers, ratios and relationships, and perhaps they do help a bit in our quest for value. But unless we adjust all such historical data to reflect today’s realities, comparing prior environments with those applicable today, or even those expected tomorrow, we will be trying to drive forward utilizing only the rear-view mirror.
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