The REIT bubble

 

Pop!

The Other Real-Estate Bubble

By ANDREW BARY

THE NATIONWIDE INFATUATION with property has spilled over into the stock market, where shares of real-estate investment trusts have soared, despite spotty operating results and higher interest rates.

The run-up in REIT shares, which have doubled since early 2003, has raised concern on Wall Street that a bubble could be forming in the $300 billion sector. "Our view is that valuations are in uncharted territory, and the group is very susceptible to a correction," says Jonathan Litt, the REIT analyst at Smith Barney. What's the downside? Litt says that shares of real-estate investment trusts could fall more than 10%. This year, the major REIT indexes are up about 10% (including dividends) after 30%-plus returns in both 2003 and 2004.

Some cracks may be starting to form in the REIT sector. The group declined 2% Thursday and was down about 3% Friday., hurt by a setback in the bond market that followed the release of stronger-than-expected July employment data Friday morning.

The two-day selloff illustrates the volatility in REIT stocks. Morgan Stanley's REIT index, for instance, dropped 10% in January and had rallied 25% from late March until the middle of last week. Still, REITs often appeal to risk-averse investors who don't recognize this.

Litt acknowledges that a sustained REIT retreat might not come soon because "a wall of money" continues to chase the sector and the entire U.S. commercial property market in which the group invests.

What could derail the REITs? Further interest-rate increases, a bursting of the property bubble, a slowing economy or a shift in investor preference toward common stocks.

Danger signs abound. The group, which offered dividend yields of 8.75% in late 1999, now has an average yield around 4.5%. Some leading REITs, including Vornado Realty Trust, Simon Property Group, General Growth Properties, Boston Properties and Public Storage, yield less than 4% -- comparable to the rate on risk-free T-bills. The low REIT yields mean the sector is far less defensive than it used to be.

REITs look pricey based on virtually every historical financial metric: dividends, dividend yields relative to Treasury rates, and various earnings measures, including funds from operations, or FFO, and adjusted funds from operations, or AFFO. In fact, REIT dividend yields are at a 30-year low. And one measure of REIT's attractiveness -- their yields minus Treasury-bond yields -- is close to zero for the first time in seven years.

The REIT run-up has generated less attention than the surging prices of homes throughout the country. REITs don't own single-family homes, but they do control office buildings, apartment complexes, shopping centers, warehouses, storage facilities and other types of income-producing properties. The three biggest sectors are apartments, malls and office buildings. There are nearly 200 publicly traded realty trusts.

REIT INVESTORS HAVE SEEMED unconcerned about rising yields on Treasury paper, including the move in the benchmark 10-year T-note to 4.4% from a June low of 3.9%. As income vehicles, real-estate investment trusts become less attractive when yields on alternative investments move up. Short-term bond rates, now at 3.25%, probably are heading to 4%. That could hurt realty trusts that rely on floating-rate debt.

"There has been an enormous demand for yield and enormous demand for real cash income," says Greg Whyte, a REIT analyst at Morgan Stanley. "A lot of people are surprised at the amount of money chasing real-estate assets and REIT stocks." Where there once were three to five bidders for a $1 billion "trophy" commercial property, now there could be 20 or more.

Many Street analysts, including Litt and Whyte, have underestimated the power of the REIT rally. Earlier this year, one of the most prominent bears, David Shulman retired as the senior REIT analyst at Lehman Brothers. Shulman then was teased by Steve Roth, the influential and outspoken chief executive of Vornado Realty, one of the biggest owners of office buildings in Manhattan. Roth wrote in Vornado's annual report: "What can I say to my dear friend David, who has an IQ of 250 and had a three-year sell on Vornado with a $43 average target. I'm sorry, David. I just couldn't resist." Vornado now trades at 85.

The upside potential in REITs may be limited, barring a drop in long-term rates. REIT profits are rising, but outside the hot shopping-mall sector, the gains haven't been large. Profit growth could run at 6% to 7% annually in the coming years, barring an economic downturn.

OFFICE REITS CONTINUE to contend with the expiration of leases signed at high rents in 1999 and 2000. Another problem: continued corporate consolidation, which has hurt markets like Boston, where such big hometown employers as FleetBoston Financial, John Hancock and Gillette have been taken over. Apartment REITs are only starting to recover after a tough stretch in which occupancy and rents were pressured by the growing trend toward home ownership.

"REITs are being priced for perfection," says Peter Siris, who heads Guerrilla Capital, a New York investment firm. "REITs have benefited because the economy has stayed strong while rates haven't gone up. But I don't think you're going to have a decent consumer economy and lower rates forever." Siris points to steady insider selling by REIT executives as a sign of the sector's overvaluation.

Tables: Pricey Properties | High-Yield Alternatives1

REITs can pass along their profits to investors free of federal corporate income taxes. Since 2000, their shares, on average, have more than doubled, while prices of single-family homes nationally are up by more than 50%-with some hot markets in California, Florida and the Northeast gaining 100%. The recent REIT weakness may not bode well for America's inflated home market because the key factors that affect REITs -- interest rates and the economy -- also influence home prices.

It's notable that REIT shares bottomed just as the technology bubble was about to burst in March 2000. That was a time when many investors decided that commercial property was being rendered obsolete by the Internet. The thinking was that Americans were going to do their shopping at the likes of Amazon.com, eToys and Webvan (an Internet grocer) while doing their banking online.

The opposite is true now. Institutional investors are clamoring to buy virtually every kind of commercial real estate, not just in the U.S. but around the world. "There's a global rush to buy real estate," Litt says. "It's driven by a desire to own hard assets, diversify and buy into a group that has been working."

The yield demanded by institutional buyers on U.S. commercial property has fallen to the 4%-6% range from 9% as recently as 2002. These yields, called capitalization rates, are based on the annual income generated by a property, divided by its purchase price. Litt points out that cap rates outside the U.S. now are comparable to those domestically, reflecting the growing efficiency of worldwide real-estate markets and the tens of billions of dollars looking for opportunities.

Cap rates are distinct from dividend yields. Dividends on REITs are a result of the income thrown off by the underlying properties and the mix of financing -- common stock and debt -- used to finance the properties.

ONE CAVEAT: REIT DIVIDENDS didn't benefit from the cut in the federal tax rate on dividends two years ago. Thus, they're disadvantaged relative to payouts on common stocks. The after-tax dividend yield on a REIT yielding 4.5% is around 3.2% for an investor in a high tax bracket. An investor could buy common shares of non-REITs yielding 4% and get an after-tax yield of 3.4% -- beating the after-tax REIT yield.

A month ago, Litt did a computer screen and found that 88 companies in the S&P 500, S&P MidCap 400 and S&P 600 Small-Cap indexes had higher after-tax yields than the average REIT, up from just 27 in May 2003. The table, High-Yield Alternatives, lists some high-yielding alternatives to REITs, including the Baby Bells, Merck, Altria, Citigroup, Bank of America and Sara Lee.

What's the REIT bull case? Mike Kirby, the director of research at Green Street Advisors in Newport Beach, Calif., says that, if the U.S. is in a sustained period of low interest rates, REITs are apt to perform well. "The valuation question is tied up with the bigger-picture question of whether we're in a low-return environment for a long time. If that's the case, the 4.5% dividend yield on REITs doesn't strike me as too bad," given expectations that REITs' profits will rise 6% to 7% annually.

But Kirby and others acknowledge that REITs are likely to perform badly if the 10-year Treasury is heading toward a 6% yield.

REIT executives dismiss the bubble talk, pointing to the increasing demand among institutional investors for "alternative assets," as well as the underinvestment in real estate by pension funds and endowments relative to their equity holdings. The U.S. commercial property sector is pegged at about $5 trillion, about half the size of the S&P 500 index.

REIT enthusiasts say that commercial real estate has undergone a revaluation that's unlikely to reverse, driven in part by the increased cost of new buildings, which reflects higher costs for land, steel, copper, cement and other materials. The cost of putting up a new office building in Manhattan can run a stiff $650 a square foot -- if a builder can find a lot to put it on.

IN DISCUSSING the real-estate bull market in his annual shareholder letter, Vornado's Roth wrote: "It may be caused by low interest rates. It may be caused by excess liquidity in the worldwide system. It may be caused by the flight to hard assets. It may be technical -- worldwide institutions are under-allocated in this asset class; or it may even be for who knows what. And, it is a bull market in the face of flattish rents. Some think it is a bubble. I do not....Over the past several years, real estate has been repriced. I believe this is a long cycle move. Get used to it; give or take 10%, these prices are here to stay, for some time."

Buyers have been paying record prices for all types of real estate, including the Trump Place (top) and Aston (bottom) apartment buildings in Manhattan.

In part, demand for REIT shares is coming from institutional investors, redeploying money returned to them by firms that invest privately in real estate. Many funds are taking advantage of the bull market to monetize their holdings -- and reap sizable fees. This creates reinvestment demand among investors, which is being channeled into the REIT market.

REITs tend to be valued based on measures other than earnings. In fact, their followers tend to ignore reported earnings, which are based on generally accepted accounting principles.

Why? GAAP profits require a noncash charge for depreciation expense, which reduces reported earnings. REIT investors deem depreciation to be a phantom charge, like the depreciation of a cable TV facility, because the value of the underlying property probably isn't really falling. The preferred profit measure is funds from operations, essentially reported earnings with depreciation and certain other costs added back in.

The problem is that, based on FFO, REIT stocks are at record valuations. The group trades for 15 times projected 2005 funds from operations, versus an average multiple of 11 during the past dozen years, according to Morgan Stanley. The REIT FFO multiple is almost as high as the S&P 500's price-earnings multiple of 17, based on projected 2005 operating profits. That's a rarity; historically, the FFO multiple has been much lower than the S&P's P/E. The forward 12-month REIT FFO and S&P 500 P/E are about the same.

FFO, however, overstates true REIT profits and cash flow. A better measure, according to Kirby and other analysts, is adjusted funds from operations, which takes FFO and strips out ongoing and necessary expenditures that realty trusts typically capitalize. For apartment REITs, it's the cost of new roofs, carpets, drapes and appliances. For office REITs, it's the cost of improvements to space rented to tenants on long-term leases, as well as commissions paid to brokers.

While the gap varies by REIT, the difference between FFO and AFFO is often 25%. "The capital expenditures you deduct are really akin to the recurring cost of running the business," Kirby says. "To not factor them in is to miss a lot of information." Office REITs tend to have a big gap between FFO and AFFO while storage REITs, like Public Storage, usually have a small difference.

Measured by AFFO, REIT valuations looks particularly stretched because the typical company trades at about 20 times estimated 2005 AFFO, considerably above the S&P 500's P/E ratio. And REIT dividends average about 90% of AFFO, a high percentage. In contrast, the S&P 500's payout ratio is around 30%. This means the average company in the S&P has far more room to raise dividends than the typical REIT.

Equity Residential, the leading apartment REIT, is likely to have $2.44 a share in funds from operations this year. That's less than the $2.63 it earned in 2001, yet its shares, at their recent price around 40, were 60% higher. And its annual dividend of $1.73 will barely be covered by the $1.86 in AFFO it's likely to generate in 2005.

Equity Office Properties, a leading office REIT, has risen 20% this year, to 35. Its projected 2005 FFO of $2.52 a share (excluding losses on property sales) is less than what it earned in 2000. Boston Properties, a favorite among REIT investors because of its exposure to two of the hottest office markets, Manhattan and Washington, D.C., has risen 18% this year, to a recent 76. It trades for a lofty 18 times estimated 2005 FFO, 25 times projected 2005 AFFO and yields just 3.6%.

REIT enthusiasts' counter that, while valuations may be stretched, based on FFO, AFFO or cash flow, they're still reasonable based on private-market values. The reasoning is that if Boston Properties liquidated its portfolio, it would realize more than its current stock price after paying off debt.

AGGRESSIVE INSTITUTIONAL BUYERS increasingly are outbidding REITs when properties come up for sale. The non-REIT buyers are willing to use more leverage -- as much as 90% debt financing -- while REITs generally employ a roughly 50/50 mix of debt and equity. A similar situation exists in the home market, in which buyers making down payments of as little as 5% are helping to fuel demand.

The cautious stance of REITs regarding acquisitions is another sign of a frothy market. Boston Properties has been a net seller of office buildings, while Vornado has shifted gears and has sought real-estate plays in the stock market. Vornado is part of a group that purchased Toys "R" Us for $7 billion, and it took a sizable position in Sears Roebuck last year, prior to Kmart's deal to merge with Sears, because of Sears' valuable real estate. It now owns about $400 million of Sears Holding (SHLD) stock. Vornado issued nine million shares on Thursday at 86.75, leading bears to conclude that it wants to raise as much as it can before REIT stocks decline. The Vornado deal wasn't a winner because the stock fell $1.50 Friday to 85.50.

"Given our underwriting standards and our return requirements, we are seeing a paucity of acquisition opportunities," said Ed Linde, the chief executive of Boston Properties, on the company's second-quarter earnings conference call in late July. Boston Properties recently announced a $2.50-a-share special dividend, reflecting proceeds from property sales.

LINDE CITED ANOTHER SIGN of an overheated market. While buyers of office buildings historically have favored properties with high occupancy levels, many potential purchasers now prefer buildings with sizable vacancies because they assume they can push through big rent increases. The reality is that while office rents in key markets have firmed, many office REITs still are getting lower rents on new leases than on expiring leases signed in the 1999-2001 period.

Manhattan remains a center of the real-estate boom. Apartments fetch $1,000 a square foot or more. Thus, a modest-sized two-bedroom apartment can cost $1 million. Prime office space on Park Avenue is going for as much as $100 a square foot -- two times the rates for similar space in Boston and San Francisco.

Equity Residential, the country's largest apartment REIT, recently agreed to pay $816 million for three apartment buildings in Trump Place in Manhattan. That worked out to nearly $600,000 per apartment and a capitalization rate of only 4.5%. Bulls cited the opportunity for Equity Residential to turn the apartments into condos and sell them for a sizable gain -- although the buildings' seller presumably was aware of that possibility.

APARTMENT REITS ARE BACK in favor, partly because investors are figuring that they may engage in wholesale condo conversions to capitalize on the roaring condo market. Watch out if the condo market cools.

Elsewhere in Manhattan, another rental apartment building, the Aston, on the now-fashionable strip of Sixth Avenue in the mid-20s, recently was sold for $195 million to Archstone-Smith, another real-estate investment trust, according to the New York Post. That works out to $800,000 per unit and $1,000 a square foot. The Aston sale could be the richest ever for an apartment building on a per-unit basis. The Aston and Trump purchases reflect an effort by apartment REITs to upgrade their portfolios by buying properties in hot markets and selling them in weaker markets in the South and West, where rents are soft and barriers to new construction are low. The benefits to investors from this strategy are unclear because REITs are accepting earnings dilution by buying high and selling low.

Mall REITs have enjoyed some of the strongest profit gains because of a robust consumer economy. Simon Property, the leading mall REIT, recently reported a 16% gain in second-quarter FFO. Its FFO is expected to rise 11% this year and 6% in 2006. Simon, however, isn't cheap at 80, trading for 16 times projected 2005 FFO and 22 times AFFO.

The mall REITs face a challenge because of growth in off-mall retailers like Target and Wal-Mart Stores and the consolidation among department stores, highlighted by the coming merger of Federated Department Stores and May Department Stores, which will result in the closing of anchor stores in many malls. Guerrilla Capital's Siris notes that America "remains overstored," yet investors are more bullish than ever about mall and strip-center REITs. Siris fears that with anchor stores closing, "a lot of the second-class malls will get hurt badly."

The formerly dowdy storage REITs, led by Public Storage, have capitalized on Americans' penchant for accumulating more than they can fit into their homes. The storage industry has done particularly well in the South and West, where many homes lack basements.

Public Storage last week offered to acquire a smaller storage REIT, Shurgard Storage (SHU), for $2.5 billion, or about $53 a share -- 14% above Shurgard's share price prior to the offer. Shurgard dismissed the offer as inadequate, even though it amounted to 26 times that company's projected 2005 FFO of $2.05 a share. Shurgard was trading late last week at 52.

It's tough to say when real-estate investment trusts -- or any overheated industry group -- may cool down. Yet the feeding frenzy surrounding the group, along with the low yields and high valuations, has left many disciplined buyers on the sidelines. And it's turned some big institutions into sellers.

The California Public Employees Retirement System, which has one of the largest real-estate portfolios among public pension funds, has sold $7 billion of its $21 billion core portfolio since December. Calpers sold most of its office properties. "The prices that people were willing to pay were higher than what we felt the properties were worth," observes Michael McCook, Calpers' senior investment officer for real estate. He says the fund had bought the properties at cap rates, or yields, in the 7% to 9% range and sold them in the 4% to 6% area.

Bulls talk of a new era of permanently elevated property prices. Tech-stock boosters said much the same in 1999 and 2000, before that group collapsed. Given their huge run-up, REIT shares could be at least 10% lower within 12 months. So now might be a good time for investors to move away from them. In real-estate investing, location, location, location isn't always the most important thing. Often, timing is.

 

Pricey Properties

Table: High-Yield Alternatives⁰

The stocks of real-estate investment trusts have soared in the past year. REITs now trade at hefty multiples of their funds from operations -- a key measure of cash flow, calculated by adding depreciation to earnings -- while dividend yields have slid. Buyers have been paying record prices for all types of real estate, including the Trump Place and Aston (right) apartment buildings in Manhattan.

			Recent	52-Wk	FFO*	FFO*	AFFO**	AFFO**	Div	Market
REIT	Ticker	Type	Price	Gain	2005	Multiple	2005	Multiple	Yield	Value (bil)
Archstone-Smith	ASN	Apartment	$42.70	42.3%	$1.94	22.0	$1.42	30.1	4.1%	$8.5
Equity Residential	EQR	Apartment	40.40	35.5	2.44	16.6	1.86	21.7	4.3	11.6
Prologis	PLD	Warehouse	45.66	30.9	2.66	17.2	1.57	29.1	3.2	8.5
General Growth	GGP	Mall	46.88	49.9	3.18	14.7	2.43	19.3	3.1	11.2
Simon Property	SPG	Mall	80.53	49.4	4.82	16.7	3.54	22.7	3.5	17.7
Boston Properties	BXP	Office	76.16	42.9	4.27	17.8	3.07	24.8	3.6	8.4
Equity Office Prop	EOP	Office	35.04	32.3	2.52	13.9	1.71	20.5	5.7	14.3
Vornado Realty***	VNO	Office	87.40	47.4	4.82	18.1	3.45	25.3	3.5	11.3
Public Storage	PSA	Storage	65.28	36.3	3.37	19.4	3.12	20.9	2.8	8.4
Kimco Realty	KIM	Strip Mall	66.36	37.7	3.83	17.3	3.06	21.7	4.0	7.5

*FFO=funds from operations per share. **AFFO=adjusted funds from operations per share.
All figures related to FFO or AFFO are 2005 estimates.

***Vornado FFO estimate excludes one-time gains.

Sources: Thomson Financial; Green Street Advisors; Morgan Stanley

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High-Yield Alternatives

While REITs have become favorites of investors seeking income, many stocks offer relatively generous dividends, too.

		Recent	2005	Dividend
Stock	Ticker	Price	P/E*	Yield
SBC Comm.	SBC	$24.97	16.1	5.2%
Merck	MRK	30.82	12.4	4.9
Con Edison	ED	48.66	16.8	4.7
Verizon Comm	VZ	34.22	13.5	4.7
Bank of America	BAC	43.78	10.2	4.6
Wash. Mutual	WM	42.76	11.4	4.5
Bristol-Myers	BMY	25.10	17.6	4.5
Altria	MO	67.50	13.2	4.3
Southern Co.	SO	35.11	16.7	4.2
BellSouth	BLS	27.62	16.0	4.2
Citigroup	C	44.05	10.9	4.0
Sara Lee	SLE	20.35	14.1	3.9
J.P. Morgan	JPM	35.61	12.2	3.8
Albertsons	ABS	20.92	15.3	3.6
Wachovia	WB	51.16	12.0	3.6

*Estimated

Source: Thomson Financial/Baseline