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REIT Stocks: How to Play the Froth

REITs are not going to collapse, but as a group they are extremely overvalued by any measure, even assuming the economy has a perfect recovery.



) -- REIT stocks are overvalued and risky, despite what commentators may be saying.

The REIT index is now up nearly 30% since its recent low on Feb. 10, 2010. Furthermore, it's up nearly 140% from its low on March 6, 2009.

After this enormous run-up in stock prices, many commentators are just now recommending that people buy REIT (real estate investment trust) stocks. As someone who has been professionally involved in commercial real estate investment for 17 years, I find the timing of these recommendations to be extremely poor.

Don't get me wrong, I'm not in the extreme bear camp that believes commercial real estate and REITs are going to collapse. The government has provided too much support for that to happen.

The banks have decided to forbear and extend the debt of most REITs. Liquidity in equity markets has allowed REITs to issue massive amounts of new equity to pay down debt. Low interest rates are like rocket fuel for REITs' funds from operations (FFO). REITs are not going to collapse, but as a group they are extremely overvalued by any measure, even assuming the economy has a perfect recovery.


(MAC) - Get Report

is one example. It's once again reducing guidance. It's once again issuing massive amounts of new equity, diluting shareholders. It still has a mountain of debt. Vacancies are high. Rents are flat or falling in most markets. Yet the stock trades at a level that provides a meager and highly leveraged return on equity of less than 5% (including the new share issuance).

Simon Property Group

(SPG) - Get Report

is another example. This is a great company, but the valuation is at nosebleed levels. The leveraged cash flow yield on the equity is less than 3%. That's a leveraged cash flow ratio of more than 30 times.

Even if you take a very generous view of cash flow, that's still more than 20 times leveraged cash flow. Another way of looking at it is that Simon Property Group's current dividend is only 20% higher today than it was in the mid-1990s when the stock price was 75% lower.

Commercial real estate is nothing but a cash flow machine. If Simon Property has really grown shareholder value so much since in the mid 1990s, why isn't the dividend much, much higher?

Well, it's because almost the entire increase in "value" is because of a higher ratio, not higher cash flow.

REITs as a sector have historically been competitive with utilities because both of them derive most of their investment appeal from the dividends that they pay.

For an investor seeking a much more reasonable return on equity and dividends, almost any utility stock, or just the

Utility Select Spiders

(XLU) - Get Report

would be a much better investment. Most utilities trade at eight to 10 times free cash flow (vs. 15 times or higher today for most REITs), pay solid dividends, have solid balance sheets compared with REITs, have increased dividends every year forever (unlike REITs) and have dramatically outperformed REITs over the long term.

Of course, there aren't a lot of people short utilities, so they're not good candidates for short squeezes the way that REITs have been. If you're a speculator trying to make quick money squeezing shorts, REITs are definitely a solid way to do that.

However, that is not an investment. That is speculation. If people are going to play that game, they should understand it for what it is, so they don't get left holding the bag when the speculators move on to the next short-squeeze play.

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By any reasonable measure, the REIT index is at least 20% overvalued. That is assuming that there are no bumps on the road to economic recovery, that REITs substantially increase their dividends as everyone expects, that they have no problems rolling over debt and that they don't issue a ton of new equity that is dilutive to shareholders. To put it simply, most REITs are priced for perfection.

The current period for REITs is not, as some have suggested, comparable to 1991. From 1991 through the peak of the bubble in 2007, when


(BX) - Get Report


Equity Office Properties

, REITs were valued at ratios at least 30% and as much as 50% lower than current ratios to FFO.

To justify current FFO ratios, FFO would need rise more rapidly than it has ever risen in history. With high vacancies in almost every market, the chance of this happening seems extremely remote.

But REITs just keep going up. Well, there is a word for buying something just because it is going up. That word is speculation, and it works until it doesn't work. There are always lots of reasons people will give you why it makes sense and why this time it's different, but they won't write you a check for the money you're going to lose when the party ends and you're too slow to get out.

However, if you do want to speculate in REITs, the best way to do it would be to buy

Maguire Properties


. This is one of most hated companies in the REIT sector, but the hate is not justified. It owns great properties. It has great management. It is doing all of the right things.

Maguire Properties' shares are very cheap if the company can continue to execute and get forbearance from its lenders. The stock is currently around $4 and could easily go to $8 if commercial real estate markets and financing continues to improve. It's also a very appealing acquisition target for larger, stronger REITs with inflated stock prices and plenty of cash from recent issuance of new shares. Basically, if the REIT rally continues, Maguire Properties should outperform in 2010 the way

General Growth


did in 2009.

So if you want to roll the dice, buy some shares of Maguire Properties. But realize that you're speculating, not investing. If you want a solid dividend-paying investment that isn't at risk of falling 20% or more soon after you buy it, buy utilities such as XLU. And be careful out there.

-- Written by Christopher Grey in Manhattan Beach, Calif.

At the time of publication, Grey owned shares of Maguire Properties and the Gabelli Utilities AAA Fund (GABUX)


Christopher Grey is a co-founder and CFO of


. CapLinked makes it easier for companies and investors to connect with each other. He was previously a senior executive and partner in private equity, finance and banking for 15 years and directly involved in the origination and management of billions of dollars of debt and equity investments. Grey is a founding member of the Capital Markets Forum II of the National Association of Office and Industrial Properties. He is also founder of and on the Steering Committee of Stanford Professionals in Real Estate. He is a graduate of Stanford University, with a degree in economics.