REITs are on pace to beat the broader stock market for the seventh year in a row. Many pundits continue to argue that the sector is overvalued and due for a plunge, but shorting REITs solely on valuation has proven to be a fool's game. And those who try to perfectly time buying this sector, thinking it is too expensive, continue to be frustrated.
"Good companies are getting love, and we missed a lot of it," says one value-oriented hedge fund manager, who says he is amazed at how well the sector has done this year. The MSCI U.S. REIT Index is up 24% so far in 2006.
Office REITs continue be the best performers, with
up 45% year to date,
rising 38%, and
Equity Office Properties
( EOP) and
each jumping 32%.
Although gains at that rate will be hard to continue -- and returns likely will drop -- industry watchers note that commercial real estate has undergone a significant repricing in recent years as investors pour money into the market. This wall of money from private equity and pension funds shows no sign of slowing, which in turn will hold up REIT stocks.
In recent years, commercial real estate prices have soared as investors chase yield-producing assets. A lot of this has to do with the rapidly aging population in the U.S. and Europe. Pension funds, endowments, foreign investors and wealthy individuals continue to sink money into private equity funds and institutional money managers chasing the "yield plus" returns of real estate.
As an asset class, real estate has outperformed bonds and stocks on a one-year, three-year, five-year and 10-year basis, says Stephen Coyle, managing director of Citigroup Property Investors, which invests in public and private real estate.
Even though much of the funds for real estate investing are being raised on the private side, a lot of that money ends up in the market as REITs continue to be
Since the beginning of 2005, 14 REITs have gone private at a total transaction value of $35 billion, with average premiums of over 9% of the stocks' 52-week highs, according to SNL Financial. These figures exclude public companies' mergers, such as the pending $8.9 billion acquisition of
( TRZ) by
and private equity giant Blackstone Group.
Crescent Real Estate Equities
are the latest companies exploring a sale of themselves, according to Barry Vinocur's industry publication
The wave of buyouts generally makes sense, Coyle says, because debt is cheap and there's a fundamental disconnect between REIT stock prices and private-market real estate transactions.
"There is a wall of money out there, and yields, or cap rates, have been falling very quickly in the private market, and in many cases, faster than
analysts' NAV models," he says. NAV, or net asset value, is the way many investors calculate what a REIT stock is worth based on the underlying real estate value, rather than just a price-to-earnings metric. (As yield falls, prices rise.)
So far this year, private equity real estate funds have raised $38 billion globally, up from $37 billion for 2005, according to
Private Equity Real Estate
magazine. The publication estimates another $45 billion of funds are currently in the market or planning to come to the market in the near future.
This number only applies to "value-added" or "opportunistic" funds like Blackstone that are chasing mid-teens to 20% returns and doesn't include the billions sitting on the sidelines by institutional investors and pension funds looking to invest in stable real estate (whether in REIT stocks or direct properties).
"Fund raising is still fairly hot right now. There is still a significant amount of capital in the pipeline for real estate funds," says Gary Koster, the Americas leader of real estate funds services with Ernst & Young, which tracks private equity real estate funds. "Institutions are saying, 'We don't want our money back, just plow it into the next fund and make a 30% return again.' "
That's good news for REIT investors.
"It's hard to imagine REIT prices dropping substantially as long as there's this wall of money out there," says Mike Kirby, director of research with Green Street Advisors. "You're going to have money coming through private doors find its way into the cheap public real estate."
Even if REITs are trading at valuations that investors have never seen before, the sector is still priced to deliver decent returns, Kirby says.
However, Kirby does note an interesting issue in the sector. A year ago, REIT stocks were priced to deliver 9% returns, he says. Now, the stocks are signaling 7.5% returns -- the lowest ever.
This is newsworthy, but it doesn't mean the sector is in trouble, he says. "They definitely are not priced to deliver the types of returns they've delivered."
But a 7.5% return still makes sense, Kirby says. REITs are riskier than corporate bonds (which yield about 6%), but probably not as risky as stocks (which are supposed to return about 9%). So a year ago, you could argue that REITs were a more compelling investment. But that doesn't mean that they're no longer a good investment.
Although Green Street uses very technical discounted cash-flow models to get the 7.5% return forecast, Kirby offers a helpful back-of-the-envelope calculation for investors.
Because REITs are "total return" vehicles, they offer dividends and capital appreciation.
The average REIT currently has a dividend yield of about 4%. Historically, unlevered real estate earnings growth lags inflation by 100 basis points. Assuming long-term inflation of 2.5% going forward, that leaves you with 1% growth. Add in 50% leverage (which most REITs have), and this boosts earnings growth to a 3% long-term return.
For the near term, add in the 4% dividend yield and higher earnings and you get a 7.5% expected return.
Green Street expects REITs' adjusted funds from operations (a proxy for cash flow available for dividends) to increase 10% in 2007 and 9% in 2008 (and that growth is pretty visible based on in-place rents and other factors, Kirby says).
Of course, not everyone believes this REIT run can continue.
"In the aggregate, it's going to be hard for investors to achieve the types of returns they like in that market," says Christopher Mayer, a professor of real estate at Columbia University and a part-time research director for Oak Hill REIT Management, a real estate hedge fund.
Signs of a richly valued market, he says, include the fact that sophisticated investors like Boston Properties and Carr America (which Blackstone purchased earlier this year) have been selling a ton of assets.
"I'm quite concerned about REIT valuations," Mayer says. "I think REITs are really richly priced."
similar things were said by others last year, and investors who heeded this caution missed out on a huge buying opportunity.