Is Now a Good Time to Buy Reits?

This conversation led an interesting question which I thought I would address here.

The question,for which there are many competing answers, was: how do you value a REIT (specifically), or any other investment, for that matter?

First of all, value is always determined by buyers, for if a buyer doesn't see value, no transaction takes place. As a buyer of a REIT, I could look at it in two ways: 1) I value the investment based on an earnings yield, (Dividends), or 2) I value the investment based on the price I expect buyers to pay in the future (Capital Gains). Most investors look at both, but have a bias toward one or the other; e.g. An investor biased toward capital gains would see the dividend as a safety net, whereas an investor biased toward dividends would see capital gains as a bonus.

Historically, REIT investors have been Dividend investors looking for that potential for capital gains. REITs are not structured to function as a proxy for gains in the underlying real estate - you are looking for a stream of rental income, not title to commercial property. Based on cost of capital, legal structure, and long term holdings of the typical REIT, value comes when properties are improved and rents increase, not when the price of the underlying property appreciates.

Given this historical bias, how does the dividend yield of REITS look compared to it's long term average? I analyzed 20 years worth of data and found that current yield is 250 basis points lower than its long term average. In terms of raw yield, this is the lowest point in the last 20 years.

In addition to being at low yields historically, my research shows that in the last 20 years, REITs have given a 137 basis point premium over the 10 year Treasury rate. This spread is the compensation investors expect to receive for taking on excess risk. The current situation, however, is telling: there is effectively a negative spread . This means that REIT investors are not being compensated for excess risk. You could receive the same yield in no risk Treasuries. This premium over risk free is also at its lowest point in 20 years.

In the current yield situation, there are two possibilities that would bring yields back into proportion to their historical averages:

1) Earnings, and therefore dividends, would have to increase, or

2) Prices have to come down.

Given the capital cost and legal structure, not to mention the current real estate and capital markets, REITs lack the ability to substantially grow their earnings. Since they are required by law to pay out 90% of their net earnings as dividends to investors, they do not have the pool of retained earnings to make acquisitions that other corporations do, so they must raise money by borrowing (either bank loans or selling bonds). This is a risky proposition in today's market environment. So unless they can develop properties and raise rents, they are unlikely to be able to grow their earnings at a high rate.

Add to this the fact that the 'LBO premium' that has been built into REIT prices in the past is quickly evaporating, as PE firms need to become much more selective about their buyout targets since they have a substantially tightened pool of capital to work with. In the absence of PE firms stumbling over themselves to take your company private, you as an investor must evaluate the REIT based on its fundamentals, and that means DIVIDENDS.

That leaves the average REIT buyer looking to buy at lower prices in the future, not higher. Lower prices because the long term yield will return to mean. Lower prices because the LBO premium is gone. Lower prices because the cost of capital has increased in the wake of the sub-prime fiasco and the subsequent liquidity crunch.

As I mentioned HERE previously on this blog, Income investors should be wary of REITS because they currently offer no premium over risk free yields, Value investors should avoid because REITs are not at bargain prices, and Growth investors should look elsewhere because the structure of REITs makes it difficult for them to increase their earnings growth rates.

I know there are exceptions to my generalizations, more of which I will be exploring in the future. But as an asset class, I would not be a buyer of REITs until their prices come down. I like being compensated for the risk I take, I think it is a good habit and I encourage it in others.

Article Source: www.articlesbase.com/investing-articles/is-now-a-good-time-to-buy-reits-209244.html

About the Author:
Mike Roach is an independent financial analyst and publisher of www.ReitTrends.com. He has 7+ years on-the-ground experience in the real estate and mortgage industries