REITs Primed for More Takeouts

The stock prices remain well below the private market value of assets.
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Even after the buyout of apartment owner

Archstone-Smith

(ASN)

, industry watchers believe quality real estate investment trust stocks are still too cheap, which will lead to more privatizations and good opportunities for stock market investors.

Although debt deals for commercial real estate acquisitions are getting more onerous, there continues to exist a profound arbitrage opportunity between REIT stock values and the prices private-equity firms are willing to pay to take companies private.

"I don't think Archstone is a top," legendary real estate investor Sam Zell told investors this week at REITweek, an industry conference held in New York and sponsored by the National Association of Real Estate Investment Trusts.

Whenever Zell speaks, the real estate world tends to listen. Zell's sale of Equity Office Properties to Blackstone earlier this year has been called a sign of the top in real estate valuations -- a notion he disputes.

REIT stocks sold off heavily after the Equity Office deal, as hedge funds began shorting the sector on the belief the stocks' stellar run couldn't go any further. Since 2001, REITs have beaten the broader stock market every year.

During May, REIT stock prices fell to an 8% discount to their net asset values, or the private market value of their real estate. That represents the deepest discount since 2001, according to a recent report from Green Street Advisors analyst Mike Kirby.

He suggests investors aggressively increase their REIT allocations when such steep discounts appear.

"Of course, this strategy may prove ill-founded if the public market eventually proves to have correctly forecasted declining real estate values, but the track record of prior forecasts of this sort has been poor," Kirby wrote.

That said, the Archstone-Smith

buyout deal announced last week helped to provide a wake-up call that REITs may be too cheap, because pricing in the public market doesn't mesh with the private-market values for real estate.

"Archstone put in a floor again," for REIT prices, Mike Fascitelli, president of

Vornado Realty Trust

(VNO) - Get Report

, told investors at the NAREIT conference. He expects a lot more privatization to occur in the sector given that the stocks are so cheap relative to the underlying values.

For those who believe in the efficiency of markets, all this "cheap" talk is ludicrous. An entire asset class is not supposed to be valued much less on one market (public) than another (private).

These arbitrage opportunities are supposed to exist only for brief moments in time. With REITs, the arbitrage has existed for several years.

One problem is that the broader stock market has not fully bought into the long-term viability of the private market values being paid for deals.

Non-dedicated REIT investors need to buy into these private market values to boost the stock prices, because the dedicated REIT funds have mostly fully invested their institutional money, says one analyst at a large REIT-dedicated fund.

The buyout deals are nice, the analyst says, because they result in free call options on REIT stocks. But buyouts are not the best way to create value in the long haul because they result in real estate transfer taxes, which cut into investors' profits, he points out.

Thus, REIT investors ideally want stock prices to converge with private market values. Getting there is no simple task, given the swarm of hedge funds shorting REITs.

"Archstone-Smith was the wake-up call to hedge funds" that were shorting the sector, the buy-side analyst says. Whether the shorts stay away for good now is another story.

A perfect example of a short squeeze made possible from buyout news is

Post Properties

(PPS)

.

REIT Wrap

, an industry newsletter, has reported that Post is eyeing several buyout bids.

The stock has a short interest of 21%, which is an unusually high level for a REIT. Post shares, however, have rallied sharply over the past month.

While the juice might be drained from Post, there are two other interesting apartment REITs for investors to take a look at:

Equity Residential

(EQR) - Get Report

and

Camden Property

(CPT) - Get Report

.

At the NAREIT conference, Equity Residential CEO David Neithercut made it clear that his company would continue to buy back its own stock when it trades below its net asset value.

In the last 90 days, when the stock was between $45 and $48, Equity Residential purchased 12 million shares, or $550 million worth of stock. The company has about $450 million left on its current buyback plan, representing roughly another 5% of the float.

This provides a nice floor to a stock that some investors believe is still too cheap. Although Neithercut wouldn't provide his estimate on Equity Residential's net asset value, some buy-side analysts say it is at least $55, and possibly $60, depending on how aggressive you want to get in valuing the development pipeline.

Camden Property, which owns high-quality apartments across the southern U.S., has been beaten down this year because of weaker growth expectations for its portfolio.

Nonetheless, one REIT buysider says the stock is worth at least $80 -- and that's using multiples that are more conservative than the Archstone transaction. Camden also has a healthy buyback program in place to buy shares when they drop below fair value.

To get a feel for both stocks' implicit cap rates, or initial rates of return, you can do a quick and dirty valuation based on earnings before interest, taxes, depreciation and amortization, which are a proxy for cash flow.

Both Equity Residential and Camden are trading at 20 times last year's cash flow and offer 3.7% dividend yields. The Archstone buyout is priced at 25 times trailing cash flow, and the price represents a dividend yield of 3%.

These valuations say nothing about future growth, nor the development pipelines. But on a relative basis, both Equity Residential and Camden could be nice picks for investors looking to play the arbitrage game.