Let me start by thanking the buyers of the REIT ETF, ticker IYR, of which I own long-dated puts. Today, they bid it up, as they did yesterday in a Pavlovian manner on news that Archstone-Smith will be taken private. Hopefully, the buyers will keep bidding up REITs so I can add to my short position.
For, you see, insanity reigns in commercial real estate today. Prices of commercial real estate are as ridiculous as residential real estate was a year or so ago, and as silly as big cap growth stocks were during The Bubble. It is no different. And the end will be no different.
But because of the reckless monetary policies of Easy Al and his successor Helicopter Ben - who may differ in style and approach towards inflation targeting but does not differ in attitude towards the asset-driven economy - an ocean of liquidity has flooded the world and has to go somewhere. With the copy-cat pension and endowment funds looking wistfully at the funds which had the foresight to invest in alternative assets such as private equity and real estate ten years ago, money is pouring out of stocks and into alternative asset classes. A decade hence, those piling into alternatives will discover they were wrong, and they will wonder what happened to the asset economy of Easy Al and Helicopter Ben, both of whom should be long gone before the proverbial you-know-what hits the fan.
Indeed, much of private equity is merely leveraged equity not marked to market. Pensions and endowments could get the same effect investing in index funds by either borrowing 5x the amount of equity and investing in an index or investing in futures at 5x the rate to synthetically create an index return, turning off the TV for five years, and hiring a private valuation to firm to tell them what the market should be valued at, all the while not paying the 2 & 20 gravy-train all the ambitious Ivy League MBAs are scrambling to jump on. But we will leave private equity for another time.
Commercial real estate's cousin, residential real estate is dead. Home prices will, at best, move sideways for a decade or, at worst, fall 20-30%. But the
Greenspan Bernanke Put is alive and well, vividly demonstrated when Helicopter Ben was madly pumping liquidity into the financial system as the over-leveraged subprime market was collapsing, a market which we are now assured by the best and brightest was but an afterthought in the world of mortgages. Thus, housing prices will not allowed to fall by those controlling the printing presses of this once mighty currency. But homebuilders stocks have, and will.
Alas, commercial real estate is dead as well, and the REITs will face a similar fate as the homebuilder stocks. It's just that the patient is not yet aware he is dead.
First, I believe that the IYR ETF has seen its top. Generally, the IYR has been rising when the market has been rising and selling off or consolidating when the market has been selling off or consolidating. That has not been occurring the past few months. Instead, REITs have been struggling while the Dow and the S&P 500 hit new highs. Perhaps the ETF hit $95 or so, but I would then expect it to fail.
Why have the REITs not been following along with the market? Because spreads have widened. CMBS spreads have gone straight up since the market sell off began at the end of February. But unlike the market, spreads did not revert back to trend. Instead, spreads on A-rated collateral mortgage backed securities have risen from 100 to 200 bps whereas spreads on BBB-rated pools have risen from 200 bps to 400 bps. Only recently have the spreads come down a bit. Interest rates on CMBS products are critical for financing deals. Unless spreads come in meaningfully, the game is over.
Next, REITs are expensive. First, ignore this comparison to NAV the analysts use to justify the price of deals. I heard an analyst comment that Archstone was trading below net asset value before it was taken out while the deal price was above NAV. Net asset value is a moving target. It is based on cash flow projections and discount rates. Because discount rates have, or at least had collapsed to record lows, and cash flow projections are assuming unprecedented rental increases (all while supply is increasing), changing the assumptions can dramatically alter NAVs. I can assure you that five years ago, no analyst, not a single one, was arguing that the net asset values of REITs were as high as they are today.
Instead, let us look at multiples. Using information on 118 REITs in the Russell 3000 comprising approximately 95% of the market cap of all REITs in the index, REITs are trading at
25.2x 2006 earnings
28.4x 2007 estimates
26.1x 2008 estimates
compared to S&P 500 (excluding financials) multiples of
20.1x 2006 earnings
17.8x 2007 estimates
15.8x 2008 estimates
Thus, REITs are trading at premiums of 25% on 2006 earnings, 59% on 2007 estimates and 64% on 2008 estimates.
But, the real estate bulls will tell you, earnings are not a proper metric to value REITs. Instead, one should use something called "Funds from Operations" (FFO). Why? Because, the thinking goes, an investor should exclude depreciation since real estate values only go up! Thus, we back out capex and depreciation and amortization (D&A) from free cash flow to obtain FFO. Putting aside the somewhat intellectually vacuous reasoning - do you spend any money keeping up your home? - and taking the argument at face value, REITs are currently trading at 13.8x trailing FFO. This seems reasonable compared to 20.1x 2006 earnings at which the market ex-financials is currently valued.
Or is it? Why compare earnings to FFO? Is it not consistent to compare the FFO of REITs to the market? When backing out capex and D&A from free cash flow, the S&P 500 ex-financials is currently trading at 9.2x FFO. Thus, REITs are trading at a 50% premium to stocks based on FFO! Considering that REITs used to trade at 7x-9x FFO a few years back before everyone went ga-ga over real estate, I would guess that this spread is as wide as it has ever been.
This astonishes me as REITs must distribute most of their cash flow as dividends to qualify for tax-exempt status whereas corporations retain earnings to grow. Corporations have a source of capital to fund organic growth whereas REITs have no (or little) source of retained capital to grow cash flow. Growth must come from increases in rents. Thus, corporations should trade at a premium to REITs, not at a discount.
Well, the bulls may retort, the dividend is higher. True. The market-weighted dividend on the 118 REITs is currently 4.3%. (It is 2.9% trailing for the IYR and 3.1% forward.) However, REIT dividend yields used to trade within a range of 6%-10%. Also, since REITs pay out about 80% of their cash flow in dividends, the quick thumbnail calculation for cash available for dividends is 5.3% (4.3%/0.8) whereas this same calculation for the market (this time including financials) given a 30% payout ratio yields 6.0%. So REITs, which have an inherently lower rate of organic growth than stocks, also yield less when using cash available for distribution.
Lastly on valuation, complexes such as apartments and strip malls in suburbs are being purchased with an assumed cap rate - that is "capitalization" rate, similar to an internal rate of return - of 4%-5%, below the cost of financing. For prime properties, the rate is lower still. Free cash flow yield is often even lower. Thus, to merely break even, rents are going to have to go way up. Frankly, as an investment, I think that's nuts. I'll take a 5.25% T-bill rate, thank you very much.
Finally, I began receiving a magazine in the mail entitled Real Estate Portfolio. It is published by NAREIT. The publication has nice pictures of buildings and cityscape vistas, and is printed on heavy, glossy paper. Although the articles are somewhat lacking in depth, it is a nice magazine. However, I have no idea why it began showing up on my desk. I never asked for it. I did not subscribe to it. I didn't even know it existed. And apart from my own home, I don't invest in real estate. Is it being sent to anyone who looks like an investment professional? The address box has my CFA designation attached at the end of my name. Perhaps the CFA Institute sold them the list, I don't know. I just figure that when the likes of me start receiving unsolicited magazines about really hot markets of which I am more interested in shorting than investing, I know the end is near.
And the end will come. For that I am certain.