In a low nominal growth world, yield is indeed poised to be a scarce commodity, and yield-driven equity asset classes have multiplied to satisfy demand. In some cases, there is dubious financial engineering afoot. We would caution that well-covered dividend paying stocks and REITs are proven equity-plus-yield instruments. Publicly traded LPs and MLPs are much less proven and have not evidenced consistent durability thus far.
The REIT universe is poised to enjoy a unique catalyst in the form of an industry re-classification to its own market sector. The historical market cap of all publically traded REITs in the U.S. has expanded from $1.5 billion in December 1971 to $939 billion in December 2015; as a result, MSCI will separate all non-mortgage REITs into its own sector on August 31st (REITs were previously part of the Financials Services sector). The stand-alone REIT sector is expected to be the 2nd-largest sector (after Financials) in the small cap and mid cap value indices (the Russell 2000 Value and Russell Mid Cap Value benchmarks). Historically, many investors did not look at REITs as being compatible with a stock portfolio. Legally speaking, REITs are not stocks, and were instituted as a liquid way for investors to hold real estate assets in a tax-friendly manner. The tax-friendly treatment came at a cost (namely, fewer degrees of freedom to disburse income), but some of these limitations have been engineered-around financially. With this pending re-classification and the market’s thirst for yield, a further discussion is warranted.
According to JP Morgan, looking at the existing holdings of about 7,500 1940 Act mutual funds consisting of nearly $5 trillion in assets, index-oriented portfolio managers are roughly 47% underinvested in REITs versus the benchmarks. The largest impact will be on small and mid-cap universes, as only ~15% of the 182 publically traded equity REITs have market caps in excess of $10 billion. As Cambiar considers the technical buying pressure likely to impact the pending REIT sector, we are careful to consider the absolute and relative valuations at an individual level. We primarily rely on four valuation techniques to evaluate REITs: Price to Net Asset Values, Implied Cap Rates, Price to Adjusted Funds from Operations and Relative Dividend Yields.
Price to Net Asset Values
As an asset based valuation methodology, P/NAV considers the current market prices of a REIT’s assets (properties) and its liabilities (mortgages), and compares it to the value of the REIT’s equity. As valuations within particular subsectors and geographies move around based on macro variables, this technique relies heavily on accurate mark-to-market analysis. Since 1996, P/NAV has averaged at 101%, but has trended from discounts of 78% to premiums of 130%. REITs currently trade at 97% of net asset value, although subsectors such as self-storage, healthcare and lodging are trading significantly higher, reflecting a disconnect in public and private asset pricing.
Implied Cap Rates
Related to NAV analysis, Implied Cap Rates compares the estimated profitability of a particular asset (net operating income) to the property value. The higher the implied cap rate, the more profits are expected from a particular asset. Implied cap rates are dependent on fundamental business performance and can vary greatly across the various REIT sub-sectors. As an example, self-storage generates impressive returns with little reoccurring capital expenditures and limited operating expenses, while shopping malls require significantly higher upkeep and labor. As a benchmark, it is useful to look at the spread of implied cap rates relative to the 10-year treasury yield. Following the financial crisis in 2008, the spread has trended between about 250 and 450bps. At 366 bps, REITs are slightly above long-term averages – although this premium is likely impacted by treasury yields remaining at depressed levels due to accommodative monetary policy.
Price to Adjusted Funds from Operations (P/AFFO)
P/AFFO is a modified version of price to earnings to encompass the fact that real estate typically does not depreciate, and should therefore be excluded from valuation analysis. The share price is compared to the funds from operations (essentially net income excluding depreciation) and benchmarked over time. Since 1993, the REIT universe has traded between 8x and 26x AFFO, with a 16x average. At 21.5x, the REIT market reflects higher ongoing internally funded growth, a cheaper cost of capital, and investors’ thirst for income-oriented securities. AFFO multiples can also be compared to the broader market earnings such as the S&P 500. The REIT sector’s AFFO metrics currently trade at 130% of the S&P 500 earnings, which is above the 110% average premium.
Relative Dividend Yields
Dividend yields have traditionally represented about 50% of total returns from REITs, although recent real estate-oriented equity performance has been outstanding. Since 2009, the average REIT yield has been approximately 4%, as payouts have mirrored net operating income growth. Relative to the 10-year treasury, the REIT universe yield generally carries a 100-200 bps premium. During a period of rising interest rates (it’s been a while…), REITS that have the ability to re-price their rents (e.g. hotels, self-storage) typically out-perform the broader universe, as their business models compensate for higher interest expenses.
Current Opportunities in REITs
Given the strong thirst for yield, many REIT stocks have performed well in recent years, and subsequently are not trading at inexpensive levels as an asset class. While tax-advantaged dividend payouts are a primary attraction for many REIT investors, operational quality varies considerably. On a fundamental level, some pockets of the REIT market look to be downright unattractive; mall-based REITs are one such example. As such, Cambiar remains highly selective in the REIT space, despite the imminent technical catalyst.
Jeffrey H. Susman - Investment Principal