Thursday, February 28, 2013

REITs are Overvalued

It seems like the Federal Reserve's zero interest rate policy (ZIRP) is having its intended effects all across the market with investors being forced to replace traditional income producing assets, such as treasuries and investment grade bonds, with riskier substitutes like REITs, BDCs, and junk bonds.  Risk averse investors sure have short memories as all three asset classes were hit particularly hard during the 2008-2009 credit crisis, however, as Howard Marks has been saying recently, they may not have any other alternative and are becoming essentially forced buyers.  Whereas forced sellers tend to create the best buying opportunities (see AIG), forced buyers are just the opposite, they distort the market and end up overpaying for certain assets, REITs in particular being one.

REITs (real estate investment trusts) are corporations that specialize in real estate based activities, and by electing to be a REIT, can avoid federal income tax as long as they pay out 90% of their taxable income to investors.  REITs are a popular way for retail investors to gain exposure to commercial real estate investments they would otherwise be restricted from due to vast funds needed to build a diversified portfolio of assets.  Publicly traded REITs also give the added benefit of liquidity that owning a strip mall outright wouldn't allow the average investor.

REITs definitely have positive qualities, but there's been many articles written recently on sites like Seeking Alpha that essentially ignore the price investors are currently paying.  Brad Thomas is a particularly ever present voice pushing REITs as a safe investment for those seeking income, focusing primarily on the dividend yields and the fact that some have never been cut (how'd the workout for GE?) or comparing REITs dividend yield to other income producing assets (aka reaching for yield). 

Total return should be the focus of every investor (capital gains and dividends), and at a price-to-adjusted funds from operations (P/AFFO - the REIT equivalent of P/E), investors are paying an over 21 times multiple, quite rich.  A 21 P/E might be appropriate for a growth stock that requires little in the way of capital investment, but REITs inheritantly require a lot of upkeep and generally have to fund growth through stock issuance and not retained earnings.

The inverse of the P/AAFO ratio is the AFFO yield, which can be thought of as the capitalization rate that the market is assigning to each REITs underlying assets.  Institutional buyers should be able to compare the cap rates they're getting the in private market with those available in the publicly traded sector and act accordingly.  If they're getting a better deal in the private market, simply purchase a portfolio of office buildings, malls, or apartment buildings outright.  At this time, it appears individual investors are acting irrationally and bidding up the prices of REITs compared to the underlying value of their assets.

Below are the 20 largest holdings of the Vanguard REIT Index Fund, one of the largest REIT focused mutual funds or ETFs.  The 2013 AFFO estimates are the average analyst estimates per Bloomberg.

During "normal times" cap rates are usually in the 7-10% range in the commercial real estate market in the private market, for instance, our friend Gramercy Capital  is targeting acquisitions in this range.  At today's prices, investors are willing to pay for publicly traded REITs at 4.6% cap rates, almost double, something is off here

As an investor in Gramercy Capital, this inefficiency is great, management can pick up real estate using cash on hand at 7.5%-9.0% cap rates and then have the public markets eventually value those same assets much higher (assuming of course Gramercy gets out of the penalty box and starts paying a dividend).  Other REITs are of course doing the same thing in order to maintain their AFFO growth and raise the dividend, however the available inventory and disconnect will eventually come to an end (possibly with the rise in interest rates). 

For the typical investor, I would be very careful adding additional REIT exposure at this time.  Many investors already have the market weight in REITs through a total stock market type index fund, so there's no reason at this point to overweight with an additional REIT sector fund.  I do feel for investors requiring income right now, but I don't think REITs are the magic answer, drawing a balance of capital gains (principal) and interest/dividends from a well balanced portfolio is a better solution than simply stretching for yield so you "don't touch the principal".

Disclosure: I own shares in GKK, recently sold GKK-A

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