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REIT Market Overheating?

(February 1, 2007)

Dear Subscribers and Readers,

Newsflash: Yesterday, the Dow Jones Transportation Average rallied 128.58 points to close at 4,916.82 – surpassing the all-important November 16, 2006 closing high of 4,881.57.  We also haven't seen a close this high since the July 5, 2006 close of 4,921.53.  In light of the latest close in the Dow Transports (not to mention a new all-time high on the S&P 400 and the S&P 600), the life of this cyclical bull market has just been extended another notch.  Subscribers should continue to be on the lookout, however, as the S&P 500 has just notched its 8th straight month of gains – and according to TickerSense, the S&P 500 has not notched 9 straight months of gains since the nine-month period ending March 31, 1983.  A potential catalyst for a correction from current levels?  Possibly, the February 9 to 10th G-7 meeting during the weekend after next – should there be an unexpected announcement about the Yen – which would serve to strike a blow in the current Yen carry trade.

Before I begin this commentary, I just want to make a note that I will be taking a break from writing this weekend.  It is my birthday, and I have decided to “break away from tradition” this year and take a break during my birthday instead!  Instead of our usual weekend commentary, I have brought in one of our regular guest commentators, Bill Rempel, to write for us instead.  However, rest assured – I will continue to keep track of the stock market and watch it “like a hawk” over the next week or so.

I would like to take this opportunity to explore a subject that we haven't really covered in our commentaries – that topic being Real Estate Investment Trusts (REITs).  For individuals who want to diversify into real estate but don't want to directly invest in properties or who want to remain relatively liquid, the best way to invest in real estate is through indirect means, such as through buying shares of REITs (they are traded on the exchanges), real estate exchanged traded funds (ETFs), real estate service companies, or mortgage-backed securities.  Today, the global REIT market is approximately $750 billion, with the U.S. making up the majority of the market at $400 billion.

For those who have not read John Mauldin's January 19, 2007 commentary entitled “Capital Keeps Falling on my Head,” I urge you to do so right now.  In that commentary, he discusses the thoughts of Sam Zell, the soon-to-be-former owner of Equity Office Properties Trust (word is that Vornado Realty will bid $40 billion for it soon).  More specifically, Mr. Zell believes that the bidding war for Equity Office Properties Trust and the most recent rally in the prices of REITs (the FTSE NEREIT All REIT Index has risen seven years in a row, rising approximately 220% from the end of 1999 to the end of 2006) is a reflection of the immense liquidity out there and the desperate search for yields in the market place by baby boomers – resulting in the compression of yields and spreads all across the world.  The REIT market is the latest “victim,” so to speak – and things will most likely not return to “normal” for a relatively long time.  To put the 7-year rally in REITs in perspective, following is a chart showing the returns of the FTSE NAREIT Index vs. the returns of some major stock market benchmarks and the U.S. Treasury 10-year note, courtesy of the latest “REITWatch” report from the NAREIT:

Selected Indicators of Equity Market Performance (Period ending index levels and percent change, as of December 31, 2006)

As shown in the above table, the performance of U.S. REITs since the beginning of 2000 has been nothing short of phenomenal.  More importantly, this huge rally started at the same time the equity markets peaked in early 2000 – as liquidity and other risk-seeking capital struggled to find a new home as the stock market underperformed.  To a certain extent, this is still occurring today, as both pension funds and retail investors have continued to diversify into real estate investments over the last 12 months.  Based on data from, approximately $6.1 billion were “put to work” in real estate mutual funds and ETFs in 2006.  Moreover, since the beginning of 2002, assets held by real estate funds have risen from less than $12 billion to over $75 billion by the end of 2006.

Whether this outperformance will continue going forward will depend not only on liquidity, but on investors' appetite and preferences to put more real estate in their portfolios.  This will also depend on the amount of net issuances of REITs.  Interestingly, while REIT capital offerings totaled $48.4 billion in 2006 (surpassing the previous record of $45.2 billion in 1997, when the REIT market made a significant top), there was a corresponding $70 billion in private equity activity in the marketplace – resulting in a net issuance of negative $20 billion in 2006!  This and other M&A activity totaling more than $110 billion drove REIT prices higher in 2006.  According to NAREIT, the best performers last year were Office REITS (with average returns of approximately 45%), followed by apartment REITS (+40%), retail, and industrial (both returning +29%).   The worst performer was manufactured homes, but even that REIT class managed a return of 15.3%, just 50 basis points less than the return of the S&P 500 in 2006.

By any measure, a $400 billion market is relatively small – meaning that the market can do anything in the short-run.  However, UBS estimates that there is approximately $3.4 trillion worth of “investable” real estate in the United States today – suggesting that a lot more paper can be issued (either sold to the public or to private equity firms) if prices continue to rise.  Perhaps the best way to show the stretched valuations of REITs today is through the following chart showing the spread between the yield of equity REITs vs. the yield on the 10-year treasury note, courtesy of NAREIT

Monthly Equity REIT Dividend Yield Spread (January 1990 - December 2006)

As the above chart shows, the yield on equity REITs is now trading at a negative spread vs. the yield of the 10-year treasuries – suggesting that most investors are now speculating on continued appreciation of REIT prices as opposed to seeking income.  Interestingly, the last time REIT spreads were at current levels was in 1997 – when REIT prices made a secular peak.  The REIT market as a whole would decline by more than 18% in 1998 and another 6.5% in 1999.  Quoting Prudential's 1Q “Market Perspective” on REITs:

By all historic measures, REITs are richly priced today. Most obviously, REIT dividend yields have fallen dramatically over the past three years. Last year, REIT yields declined another 100 bps, while the 10-year Treasury bond yield rose about 30 bps. As a result, the spread between REITs and the 10-year Treasury turned negative in January, plunging as low as –101 bps in November before narrowing slightly before year-end. Likewise, the average spread between REITs and Baa corporate bonds widened to –270 bps last fall, and though it has narrowed somewhat since, it remains well below the long-term average (–104 bps) since 1996. Record high multiples confirm that investors are paying a premium for REIT cash flows today.

REIT price-to-FFO multiples, the REIT market's version of P/E ratios, have climbed steadily since 2002. In 2005, P/FFO multiples surpassed the average P/E ratio for the S&P 500 for the first time and are now at all-time highs.

FFO stands for “funds from operations.”  Given the cyclical nature of the real estate market vs. companies on the S&P 500, a P/FFO ratio that is higher than the P/E ratio of the companies on the S&P 500 definitely looks overstretched to me.  Moreover, Prudential reports that REIT valuations in the public and private markets has gotten much narrower in recent months, suggesting that one huge pillar of support for REITs – private equity M&A – may be disappearing.  Sure, there is still a huge pool of private equity money sitting out there waiting to do deals in the commercial, retail, and industrial real estate markets, but the valuations definitely do not look as compelling as it has been.

So Henry, what do you think will be the catalyst for a peak in the REIT markets, not only domestically, but globally as well?

Obviously, the strength of the REIT market will depend to a significant extent on the strength of the global economy, and on this score – especially given the reacceleration of the U.S. economy in the 4th quarter of last year, the world economy is still supportive of further strength in the REIT market.  Liquidity also remains ample – as the combination of the growth in hedge funds and the commercial mortgage-backed securities markets have been very supportive of real estate prices.

Moreover, according to Prudential Real Estate Investors, there is still potential improvement in both the office and the apartment REIT markets.  Quoting from Prudential:

Although plenty of office markets are still struggling with high vacancies and lackluster absorption, the U.S. office market as a whole clearly has moved into the growth phase of the cycle. According to preliminary data from Torto Wheaton Research, the average office vacancy rate in its coverage universe declined from 13.6% at year-end 2005 to 12.5% in 4Q06, its lowest level since 2Q01. With significant new supply still years away in most markets, office rent and NOI growth should be very strong over the next few years. Asking market rents are starting to move higher in most major markets, and more leases that were signed at the bottom of the rent cycle will begin rolling over in the next 12 to 24 months.

The slowdown in the U.S. housing market produced mostly positive effects in the apartment market last year. Apartment fundamentals continued to improve as vacancies declined and rent concessions became increasingly rare. More importantly, apartment values remained firm despite the abrupt retreat of condo converters, who have been the most aggressive source of investment capital in recent years. Transaction activity slowed and cap rates for inferior assets and properties in secondary and tertiary markets crept higher after long-term interest rates spiked in the second quarter.

Tenant demand for apartments also remained firm last year. Falling home prices may have closed the gap between the cost of owning and renting in some markets, but they do not appear to have fallen far enough yet to impede rental growth. In addition, many renters may continue to rent until they are convinced that housing prices have bottomed out. Many apartment markets recorded healthy rent growth in 2006 as concessions were eliminated and landlords regained enough pricing power to push rents higher, particularly in the coastal markets. Near-term demand growth for apartments will depend heavily on the job market in 2007 and, hence, will vary widely by market. However, new supply should be fairly modest in most markets over the next 12 months, largely due to high construction costs.

However, given the rich valuations in the REIT market today, subscribers should be very cautious – as it probably will not take much for anything to act as a catalyst for a major peak in the REIT market.  Some specific factor that could derail the rise in REITs include:

  • A rise in interest rates – mainly on the long-end.  Recall the chart above showing the negative 100 basis point spread between the yield of REITs and 10-year Treasuries.  Sure, this may be a totally “new era” in the REIT markets but it is very difficult seeing the spread continuing to get wider on the negative side.  Should 10-year yields rise going forward, there is a good chance that REIT prices will contract as well.

  • The end of the Yen carry trade.  Like I have mentioned before, currency flows are inherently opaque – and this applies to the Yen carry trade as well.  However, given the Japanese's taste for foreign real estate, this author would not be surprised if a significant portion of private savings in Japan has ended up in the U.S. REIT markets.  Moreover, as recently as the end of 2005, the market capitalization of the Japanese REIT market was only US$20 billion – suggesting that Japanese investors would most likely have to go overseas in order to find a big-enough market to accommodate their appetite for liquid real estate investments.

  • A huge, speculative burst driving up REIT prices significantly in the short-run.  Interestingly, REIT prices (after rising more than 34% in 2006) rose another 8% for the month of January this year.  Should this trend of speculative fever continues, there is a chance that the REIT market could just “blow off” on the upside and fall on its own weight.  At this point, this seems to be the most likely case.

Bottom line: Although fundamentals in both the office and the apartment REIT markets are still relatively robust and supportive of higher prices ahead, subscribers should keep in mind that current valuations are now very overstretched on a historical basis (whether it is measured as a spread to the 10-year treasury yields or relative to the P/E of the S&P 500).  At this point, liquidity still remains ample, but given the narrowing valuations between the private and the public REIT markets, there is a good chance that private equity M&A deals may not be as robust as 2006 – suggesting that the current rally in REITs will probably be much more dependent on pension fund and retail investor inflows going forward.  Readers please stay tuned.

Signing off,

Henry To, CFA

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