Are REIT Funds' Best Days Behind Them?
There are several reasons to worry.
Commentary
As the REIT index has been climbing, investors have flooded REIT mutual funds with cash.
Of the nearly $1.6 billion that has flowed into real estate funds for the past year through April 2010, more than half has come in the past month and nearly all has come in 2010 (see chart below). In other words, investors have been putting money into real estate funds with dramatically greater velocity as prices have risen and yields have dropped.
Investors may be giddy with recent performance and the fact that REITs pay dividends. They are likely chasing REITs for at least some of the same reasons they've been pouring money into bond funds--a frantic quest for current yield. By law, REITs pay out 90% of their reported earnings as dividends in exchange for status as tax-free corporations.
Given the recent climb in prices, however, are REIT funds' best days behind them? We studied REIT funds' valuation in three ways. First, we compared the prices of the top-15 holdings in four of the most popular REIT funds-- Vanguard REIT Index Fund (VGSIX), Fidelity Real Estate (FRESX), T. Rowe Price Real Estate (TRREX), and Cohen & Steers Realty Shares (CSRSX)--relative to a REIT cash flow metric called "funds from operations" or "FFO." We also compared dividend yields of REITs relative to the interest from 10-year U.S. Treasuries. Finally, we examined how Morningstar's equity analysts view REITs currently.
Source: Morningstar Direct Fund Flows
What Is FFO?
Funds from operations, or "FFO" for short, is a REIT metric that analysts use to get a handle on how much cash flow a group of properties or a REIT is generating. To get to FFO, you must adjust a REIT's net income for property sales and depreciation, which is a material non-cash charge since the IRS allows real estate companies to depreciate property at a prodigious rate that distorts the reality of a property's cash flow generation. This, by the way, is why a traditional price/earnings metric isn't the best valuation tool for REITs. REITs actually generate more cash than their net income line often indicates.
To be sure, FFO has its shortcomings. It adds back the full depreciation charge, even though, as any homeowner knows, a property requires significant upkeep; appliances, plumbing, wiring, and countless other things wear out and need replacement. But REITs uniformly report FFO, so we'll consider it with the understanding that it can provide a rosier cash flow and valuation picture than what really exists.
FFO Analysis
Morningstar's analysis showed that the top 15 holdings in four of the most popular REIT funds are trading at an average Price/FFO multiple of about 20 based on the stocks' closing prices on May 14, 2010. If we flip Price/FFO around, owners of these stocks are getting a 5% FFO yield. Indeed, the actual dividend yield on the Vanguard fund is less than 3% currently, as low as it's been in recent memory.
Of the top-15 holdings in each fund that had positive FFO for the past 12 months, only two--West Coast apartment landlord BRE Properties and retail landlord Weingarten --clocked in with price/FFO below 15. Some firms have posted negative FFO for the past 12 months due to noncash write-downs or impairments of land held for development or developments partly finished, and we left them out of our calculation. Those impairments could be reversed in the future, but they also can get worse. REITs would have to grow considerably to bump FFO yields from 5% to 10%, which is where they were around 10 years ago.
Yield Spreads Are Slim
P/FFO doesn't look lovely, and neither does actual dividend yield. Of the three funds reporting current yields as of May 14, 2010--Fidelity, Vanguard, and Cohen & Steers--none of them is more than 3%.
To put that yield in context, analysts often compare REIT dividend yields to the interest rate of U.S. Treasuries. The April 2010 edition of the National Association of Real Estate Investment Trust's (NAREIT) REITWatch newsletter shows that REIT investors are getting paid less in dividend yield to own REITs than they are in interest payments from safer U.S. Treasury Notes.
The compensation for owning REITs was dramatically better about a year ago. The second slide below, in particular, shows that REIT dividend yield, relative to the yield of a 10-year U.S. Treasury Note, is nearly at an all-time low.
REITs may offer the possibility of growth, while Treasury Notes do not, but REITs also court more risk with their debt-burdened balance sheets.
Folding in Morningstar's Equity Analysis
Trailing FFO and dividend yield analyses have their limitations. A more comprehensive analysis would average FFO over a full market cycle, especially since 2009's FFO numbers represent a recession and arguably are unduly depressed.
Morningstar's equity analysts predict companies' cash flows in the future, and their analysis paints a slightly happier picture than the one suggested by trailing FFO and yield spread analyses--but not much happier. The average star rating for 13 of the top 15 stocks in the four funds is 2.7 stars, which means that, on the whole, the stocks are trading at slightly more than Morningstar equity analysts' fair value estimates. (Two stocks, upscale apartment owner AvalonBay (AVB) and shopping center landlord Kimco (KIM), are under review.)
It's difficult to forecast cash flows because borrowing conditions can change, for example, and significantly impact REITs' results. Companies in the sector also tend to change their structures radically, selling and buying large blocks of property. Finally, apartments and hotels function with what are basically one-year and one-night leases, respectively, making it tough to normalize future cash flows. Office and industrial properties tend to have multiyear leases, often with inflation adjustments built in, so it's slightly easier to predict their results.
Each of the three valuation tests we executed has its shortcomings, but taken together they suggest there's little margin of safety for a REIT fund investor at current prices.