Once upon a time, not too long ago, REIT stocks were the Rodney Dangerfields of the equities world. They got no respect. Indeed, such had been the plight of the REIT industry for most of its history, dating back to the early '60s – a time when Ike was President and we knew “Ozzie” as the pipe-smoking guy who lived in the 'burbs behind a white picket fence – and who, for some reason, was always home – and not the geek who bit the heads off chickens. There were lots of reasons for REITs' dissing, some of them valid, and they included the construction lending REIT fiasco, the misadventures and eventual tarring and feathering of REITs' bad-boy cousins (the real estate limited partnerships) and, more recently, issues having to do with pie-eating contests, misunderstanding the cost of equity capital and refusals to consider valid buy-out offers. While the REIT industry (including NAREIT, its trade organization) and others have been doing an excellent job educating investors on the beauties (and, yes, the risks) of REIT investing, REIT stocks also happen to be in the right place at the right time, and their Dangerfield affliction has gone the way of dotcom millionaires. In short, REIT shares are no longer disrespected. Following the killing of the bear at the end of 1999, the Morgan Stanley REIT index has risen 79.5% from its December 15, 1999 nadir (266.24) to its recent (May 21) closing price of 478.01. During that time, it has outperformed just about every other type of investment known to the modern world. In the three-year period ending April 30, 2003, the NAREIT Equity Index has delivered an average annual total return of 12.86%; few other investments can make that boast. Year to date through May 22, equity REITs delivered a total return of 12.5% (per NAREIT). Of course, some scoff at these numbers, as they are total returns; they argue, “Back out the dividends, and REIT share prices have barely moved since the spring of 1999. The NAREIT Equity price-only index rose just 4.2% from May 31, 1999 through April 30, 2003.” This is a valid point – share prices are up just modestly. However, popularity is often measured in terms other than stock price appreciation, which for REITs will be modest in any event. In truth, if the flow of funds into REIT mutual funds can be used as a gauge of romantic interest, investors' love affair with REIT shares is as arduous as ever. Year to date through May 21, according to AMG Data Services, just over $1 billion has coursed into such funds, and the flows seem to be accelerating. Of course, as Bob Dylan once noted, you don't need a weatherman to tell you which way the wind is blowin'. We need only to look at REIT stock prices in relationship to their NAVs, and here the premiums are positive and rising. No, REITs are no longer Rodney Dangerfield look-alikes; rather, they are viewed as a blend of Nicole Kidman and Tom Hanks. “All right, Block, so what's your point? We already know this. Get on with it.” The foregoing is all preface to the issue of whether REIT stocks have “come too far, too fast” and are ripe for a major correction – as many “pundits” in the popular press and some analysts have been predicting. And there are plenty of reasons to conclude that REIT stocks are, today, somewhat pricey. First of all, real estate fundamentals aren't getting any better. Occupancy and rental rates continue to fall in the office market, and effective rents (taking leasing commissions, free rents and tenant improvement allowances into account) are falling even faster than market rents. The apartment and industrial markets have seemingly intractable problems of their own. And there are even concerns in the retail sector that flat tenant sales will eventually (but inevitably) kick gaping holes in re-leasing spreads when existing leases expire, thus putting the brake on retail REITs' 7% growth rates.Furthermore, REIT shares are not cheap by historical standards. Regardless of whose estimates of REIT NAVs we use, they are clearly selling at premiums. Merrill's estimated average NAV premium at May 16 was 7%, and Green Street's average NAV premium, as of May 20, was 12% (Green Street has recently been taking interest rates on indebtedness into account when determining NAVs). This compares with a zero average premium going back to the early '90s. REITs' current AFFO yield (the inverse of the P/AFFO ratio) has compressed to close to 7% (using Green Street's numbers); while AFFO yields were lower (implying higher valuations) in October 1997, that provides small comfort, as (a) the REIT market was horribly overvalued at that time (selling at an average NAV premium of 30%), and (b) that time frame marked the zenith of REITs' '95-'97 bull market.And don't forget the dividend issue. While thus far only a modest number of REITs have cut their dividends – mostly in the hotel sector – the payout ratios in some sectors, including a few larger-cap companies, have become as tight as a 17-inch collar on your humble author's widening neck. If we use reasonable assessments of required capital expenditures in an era of very demanding tenants, very few office REITs have a comfortable margin for error. And the apartment sector is even more problematic. I'm certainly not forecasting a huge new wave of dividend cuts, particularly if the economy begins to flex a few muscles and we see a bit of job growth beginning late this year. However, the dividend coverage issue and the threat of emotional trauma that would occur should a high profile REIT slash its dividend should be sufficient to deliver a blast of cold water to the faces of those who are inclined to pursue REIT shares with irrational exuberance. And I won't depress you further by reminding you that today's relatively high valuations cannot be supported by the prospects of rapidly accelerating AFFO growth rates or impending declines in cap rates from unsustainably high levels. As for the former, the average '03 AFFO “growth” rate for the 90 REITs I follow is a negative 2.5%, with a modest 3.5% AFFO growth rate next year. And cap rates are at already very low levels; many believe that they can only go up from here (for a different opinion, see below). Rising cap rates could raise havoc with REIT NAVs.However, before you head for the bathroom and begin praying to the porcelain god, let me hasten to add that there's another side to this REIT valuation conundrum – indeed, this “other side” is very compelling, and causes me to wonder whether, at least for now, those who have been accumulating REIT shares at current prices are really such dummies after all. Here's what I mean: There is a strong argument that the reasonableness of valuations depends upon one's investment return requirements. Remember back in October 1999 when the typical REIT was growing AFFO at 8-9%, bore a yield of the same amount and yet traded at an NAV discount of 15%? Did anybody want to buy REITs then? Of course not; they were too busy loading up on Priceline at 350x mindshare and going to Henry Blodgett rallies. Today, of course, it's a very different story. The 2-year T-note yields the princely sum of 1.3% and the 10-year delivers 3.3%, implying a sub-1% rate of inflation. Medium-grade bond yields have fallen into the 7% range and appear to be headed lower. Kimco recently issued a new straight preferred with a 6.6% handle.So what does that tell you about investors' expectations today? Well, they're a lot lower than they've been for decades. One way to look at this is to compare REITs' AFFO yield to the 10-year T-note. Merrill does this in its “Comparative Valuation REIT Weekly.” At May 15, the spread was 422 basis points (7.76% AFFO yield for REITs and 3.54% for the 10-year). That compares with an average spread, going back to 1993, of 353 basis points, indicating that REIT prices haven't even kept up with Treasuries. A similar story is told if we compare REIT AFFO yields to medium-grade corporate bonds; the spread was 60 bps at May 1, per Green Street data; going back to 1993, REITs' AFFO yields and the yields on medium-grade bonds have tended to trade together, making REITs reasonably priced in relationship to BAA bonds. So that suggests that, yes, REIT shares are pricey vs. historical standards, but not when current bond yields are taken into account. Now let's look at a typical discounted divided growth model, i.e., Stock Value = Current Dividend/(Required Return Rate - Dividend Growth Rate). Let's use Regency Realty, which trades at a typical NAV premium of 8-12%. Its current dividend is $2.04, and we will assume a conservative dividend growth rate of 1.5% annually. Let's make our required return on this investment 7.5%, or 420 basis points over the 10-year (the return requirement for REG is arguably lower than for most apartment, office and industrial REITs, due, among other reasons, to the type, stability and quality of its neighborhood shopping center assets). So, the value of REG would be: $2.04/(.075 - .015), or $34 – roughly where it traded on May 22. Alternatively, the same valuation could be supported by an 8% required return and a 2% dividend growth assumption. Using such a formula, Equity Office, with a $2 dividend, a 9% discount rate and a 1.5% dividend growth rate would be worth $26.67, just a bit less than where the stock currently trades. My point here is that we can easily justify today's REIT pricing as reasonable, even using low dividend growth rates, if our required rate of return is low enough – and there are, indeed, good reasons for accepting low returns today, especially for some of the safer sectors in commercial real estate. And, even in the less safe sectors, such as office properties, doesn't a 9% required return on EOP adequately discount for the sector's current difficulties and unknowns? After all, that's 767 basis points above the 2-year T-note and 565 basis points over the 10-year. How much of a risk premium do we need?A final point. It isn't out of the realm of possibility that today's REIT markets are, once again, ahead of the private markets with respect to commercial real estate valuations. Let's go back to Regency. Green Street's NAV estimate for the company is $30.39. So, at a price of $33.90, the stock's trading at an NAV premium of 11.5%, in line with the REIT industry but expensive from a historical viewpoint, right? But what if the nominal and economic cap rates that Green Street uses, 8.25% and 7.4%, respectively, prove with hindsight to be too high? What if the new economic cap rate for REG's assets is 50 basis points lower, or 6.9% (7.75% nominal), due to private real estate investors' willingness to accept even lower investment returns in a world of no inflation? Then, according to my calculations, REG's NAV would rise by $4.05, to $34.44. Then, instead of selling at an NAV premium, the stock, at $33.90, would be selling at a 1.6% NAV discount. Is the market sending us this message? In summary, don't send the men with the funny looking jackets after me just yet. I am not trying to persuade anyone that today's REIT prices are cheap, on the basis of underestimated NAVs or any other formula. My effort is simply to encourage us to think analytically before we shoot off our mouths to friends, business associates and magazine article writers regarding REIT stock valuations. REIT stocks may indeed be expensive today, but they may not be. This is clearly an area where reasonable minds can differ, and our return requirements, as well as our cash flow and dividend growth assumptions and longer-term expectations for the economy and interest rates, can make a great deal of difference. We are now living in a 1% world, and today's markets are adjusting to that. If we return eventually to a 3% world, REIT stocks would probably, with hindsight, have been very expensive in May 2003, and we will all be asking ourselves how we could have been so dumb to be buying Regency at $34 and Equity Office at $27. So you tell me where inflation, interest rates and real estate fundamentals will be two years from now and I'll tell you whether or not REIT shares are expensive today. Personally, I don't care too much, one way or the other; I have my REIT allocation and intend to retain it – even if REIT shares prove, with hindsight, expensive. But, what for what's worth, I don't think they are expensive in relationship to bonds, equities, gold or Mickey Mouse memorabilia. Ralph
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