Real Estate Investment Trusts (REITs) can be tricky to value. Though publicly traded REITs may seem similar to stocks, applying traditional stock valuation measures like P/E ratios can end up in nonsense. REITs commonly have lofty P/E multiples, but there's a reason for it. REITs tend to have high levels of "non-cash charges" on their income statements, and that can depress net income, or the "Earnings" in the P/E ratio.
For example, equity REITs (those that invest in properties instead of mortgages) can charge large amounts of depreciation against their earnings. While depreciation is a legitimate accounting expense, it doesn't actually result in an out of pocket expense for a REIT (thus the term "non-cash charge"). We could even argue that depreciation isn't an expense to begin with since property values tend to appreciate. Whatever the case, the point is net income isn't always a good reflection of a REIT's actual earnings.
Analysts prefer to use measures like "Funds From Operations" (FFO), which is basically Net Income adjusted for certain items. Specifically, depreciation is added back to net income, and gains from property sales are subtracted out. Gains are subtracted because they aren't considered to be part of normal and reoccurring income. Sometimes analysts will use "Adjusted Funds From Operations" (AFFO), which also adjusts for capital expenditures. We can look at a couple of real world examples to see what differences these adjustments can make.
Boston Properties is a $15 billion REIT based in Massachusetts. It owns and develops commercial office space across the US. The table below shows Boston's net income (NI) reconciled for FFO (figures are in millions of USD and as of December, 2012). Boston reported $289 million in net income, but its FFO was more than 250% higher, at $742 million. This was caused mainly by Boston's $453 million in depreciation. Ultimately, this results in a large disparity between valuation measures when using NI versus FFO. Based on NI, Boston's current P/E multiple is 52. Using FFO in the denominator (P/FFO) yields a multiple of 20.
Vornado Realty Trust is a $15 billion REIT based in New York. It invests in, owns, and operates commercial office, warehouse, and retail space across the US. The table below shows Vornado's net income (NI) reconciled for FFO (figures are in millions of USD and as of December, 2012). Vornado reported $617 million in NI and $571 million in depreciation. After adjustments, Vornado's FFO comes in at $1.1 billion. Once again, we see a big difference in valuation when using NI versus FFO. Vornado's P/E multiple is 25, while its P/FFO multiple is only 14.
While these adjustments are not difficult to make, they are not always practical to use. Take, for instance, an investor that buys a REIT ETF (an exchange traded fund that invests across a large number of REITs). Adjusting net income for over a hundred REITs and calculating a weighted overall FFO figure, while possible, may not be fun for everyone.
Fortunately, when it comes to REIT ETFs, dividend yields can be a simpl way to determine value. This is due to a couple of reasons. First, an ETF that holds many REITs should theoretically diversify away non-market risk. In other words, since the ETF is spread across so many REITs, the risk and return (with respect to price) of any one REIT should have a limited impact on the fund. Second, tax laws require REITs to distribute at least 90% of their taxable income as dividends.
With price risk diversified and holdings required to payout the vast majority of earnings as dividends, we can think of a REIT ETF's yield as a broad measure of value. This is similar to how real estate investors look at "cap rates" when considering income generating properties. A capitalization rate is calculated as a property's net operating income divided by its market value (NOI/MV). Generally, the higher the cap rate, the better the value (lower property price). In a REIT ETF's case, we can think of the fund's dividend as NOI and the fund's price as market value (D/P). Let's look at one last example to make this clear.
Vanguard REIT Index ETF is an exchange traded fund that tracks the MSCI US REIT Index. It's designed to represent broad US equity REIT market performance. The largest holdings include Simon Property Group and Public Storage. Based on a trailing twelve month dividend of $2.32 and a price of $68.63 per REIT unit, the dividend yield is 3.39% (D/P or $2.32/$68.63). Historically, REITs have yielded close to 7%. All else equal, this implies that current REIT yields are low and that prices are high. In addition, the current yield's 200 basis point spread to the 10 Year Treasury yield is also below the long term average spread of 300 bps. This also indicates that REIT prices are currently high relative to historical norms.
In summary, I think the REIT market, at large, currently looks over priced. There may be value here and there with individual REITs. However, finding that value requires more work than just looking at the bottom line. For those not interested in doing the extra work, I doubt that now is a good time to slap on a large and broad position in REITs just because they yield more than bonds. Whatever the position, prudent investors should take it in moderation, as part of a properly diversified portfolio suitable for their needs.
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