REIT Update

I ran the valuation this evening on the REITs.  Currently, the Dow Jones Real Estate Index ETF, ticker IYR, is trading at 9.0x funds from operation (FFO).  That is a 15% premium to the SP500 ex-financials, which is trading at 7.8x FFO. 

As I have pointed out in the past, REITs should trade at a discount to stocks, not at a premium. Corporations can retain all their earnings to generate internal growth.  REITs have to pay out most of their earnings in dividends and are more reliant upon external sources of financing to fund growth.  Thus, REITs should trade at a lower multiple and at a higher dividend yield than stocks. 

No FFO discount would put the IYR at $60.  A 10% discount to the SP500 would put the IYR in the mid-$50s.  The IYR closed today just below $71.

According to Merrill Lynch, the dividend yield on REITs has averaged 1.75% above the 10 year Treasury bond.  Currently, the IYR is yielding 5%.  With the 10 year at 3.82%, a 175 basis point premium would put the expected yield at 5.57%.  At a dividend yield of 5.57%, the IYR would trade at $63 per share. 

However, the 10 year is coming off very low levels.  If it rises back to a more normalized level of, say, 5%, that premium will shrink.  With a 5% T-bond yield, the expected yield would be 6.75%, and a normalized value for the IYR would be $52, implying a 26% decline. 

Technically, the IYR is running right up against resistance at $71-$72

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And there have been few strong up days as of late on heavy volume.

There has been a lot of short covering in the group over the past month.

I am short REITs via my ownership of the ProShares UltraShort REIT ETF, ticker SRS.

Comments

[Ryan]

I like all of your analysis here, it makes a lot of sense. However, I guess the question is, why is the IYR trading at this premium? What else is the market factoring in here? Timing is key...just playing devil's advocate, because someone could have been calling for this return to "normalcy" in the FFO multiple for years, and be none the better for it...

[Toro]

Ryan

It very well may be that REITs are being permanently revalued by the market. However, I am highly skeptical of this.

REITs are trading at a premium for a few reasons.

1. It is a residual of the past five years when there was a mania in commercial real estate. REITs corrected by 40%, and that will often be enough to trigger a snapback as buyers come in thinking its oversold.

2. More money is being allocated into REITs by institutional investors such as pension plans. They look at past returns and, as important, diversification benefits, and extrapolate those into the future. I think they will be sorely disappointed. I think returns from equities will be below historical trend for some years, but stocks will still do better than most other asset classes, including REITs.

3. Real estate is an inflation hedge. To me, this is the most powerful argument.

T.