REIT Ride Slows Down

As cap rates drop, valuations increase. Cap rates today are lower than they have ever been. They are 180 basis points lower than the average of the last 25 years.

Over the past 25 years, the closely watched NCREIF Property Index posted average un-leveraged annual returns of 9%. Backing out the declining cap rates, total returns from un-leveraged real estate would have been about 7.9% annually over this time frame.

So long as cap rates don't decline, then history tells us that total returns have approximated initial yields, Kirby says.

The problem now, however, is that investors in real estate and REITs are paying 6% initial cap rates. If total return is supposed to equal beginning cap rates, as Kirby suggests, then realistic returns for REITs are now 6%, he says.

At today's prices, that means investors get the 4% initial dividend yield plus 2% long-term annual earnings growth.

"This does not mean that it is time for REIT/real estate investors to head for the exits," Kirby wrote. "Nevertheless, pricing is now elevated to the point that investors who move their target real estate/REIT allocations toward the lower end of their allocation ranges should be rewarded in the long run."

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