Like other dividend plays, real-estate investment trusts have been roaring. As measured by the MSCI REIT index, they’ve returned 16% so far this year (including dividends) and 20% annually over the past three years, versus a 16% annual return in the Standard & Poor’s 500 index. Some wonder whether a REIT bubble is forming similar to the situation in 2007. Dividend yields have dropped to just above 3%. The total equity value of U.S. REITs now tops $600 billion.
Mike Kirby is well equipped to assess the group. He’s a co-founder and director of research at Green Street Advisors, a Newport Beach, Calif., firm. Green Street, which started in 1985, is the leading independent research firm specializing in REITs, covering 83 North American real-estate companies and 29 in Europe. This marks the 20th anniversary of Kirby’s first interview in Barron’s (“The REIT Maze,” May 24, 1993), and two and a half years since we last spoke to him (“REITs With the Right Stuff,” Nov. 29, 2010).
Green Street has an excellent record. Its Buy recommendations have returned 25.2% annually since 1993, versus 12% for all companies in Green Street’s coverage. Hold-rated stocks have returned 11.4% since 1993, and Sells have returned just 0.1% per year.
Kirby, 52, doesn’t think the overall sector is overvalued, and he likes some high-quality companies, including Taubman Centers
(ticker: TCO), Equity Residential
(EQR), and Vornado Realty Trust
(VNO). He also has some thoughts on one of the newer trends, REITs that own single-family homes.
Barron’s: Let’s get straight to the point. Are REITs overvalued?
Kirby: Let me start with the least-favorable comparisonâstocks. REITs trade for about 25 times 2013 earnings, and when I speak of earnings, I am using AFFO, or adjusted funds from operations, which is the industry’s primary earnings benchmark. The S&P 500 trades at 15 times forward earnings. That suggests that REITs are awfully expensive. But I’ll throw you a couple of mitigating points. One is that REIT earnings growth is going to be very impressive. We project 9% growth in AFFO over the course of each of the next two years, and there is no reason that it slows down much after that because we are in the sweet spot in the real-estate cycle. Over the past eight years, REIT multiples have been much higher than the S&P 500. We have to ask ourselves if this is a new normal situation.
What else do you look at?
Given the growth outlook, REITs look pretty attractive in a low-yield world. When we add it all up, we conclude that REITs are somewhere within a fair-value range, maybe at the pricey side of that fair-value range, but certainly not dramatically overpriced.
Which sectors look best?
The mall business is not just a good business by real-estate standards; I’d argue that it is just a great business. It has performed wonderfully over the past 20 years, especially at the high endâthe types of malls that Simon Property Group
[SPG], Taubman, General Growth Properties
[GGP], and Macerich
[MAC] own. These malls have done exceedingly well in good times, and their cash-flow growth has held up very well, surprisingly well, in bad times. Prospects going forward are very good.
Even with the Internet-retailing threat?
It seems that no matter what happens to the retailer environment, no matter which retailers go under, there is always somebody willing to move a new retail concept into those top-tier malls. This sector is basically trading pretty close to the REIT average on key valuation benchmarks, and yet over the long haul it’s delivered a lot more. So my first piece of advice is to overweight malls.
What else looks good?
Apartments. They have fared well over the long run. Owners haven’t had to invest as much capital to maintain their properties as is the case in other sectors. Apartments have been underperformers relative to other parts of the REIT market. The conventional wisdom is that if single-family housing is doing well, apartment rentals must not be. That’s way too simplistic. Both can thrive at the same time. We just need growth in household formation, and we are optimistic that household-formation growth is going to be pretty good in the next few years.
Anything you don’t like?
On the flip side, there are hotels and industrial properties. They tend to be systematically overpriced because investors don’t fully appreciate the capital expenses you need to keep them up. Neither one has delivered total returns on par with other sectors over the past 20 years. Hotel owners need to reinvest twice as much of their cash flow back into their properties as has been the case with other property sectors. And that doesn’t even capture the obsolescence factor. No matter how much money you spend on hotels in some markets, you are always going to have something newer and prettier come in. There are times in the cycle when it’s good to own hotels, but through a full cycle, history shows it is a tough business.
What’s your favorite mall REIT?
Taubman. We recommended it 20 years ago in Barron’s, and we still like it. It has been one of the top-performing REITs over that time period. Taubman has the most productive portfolio in the country with the highest sales per square foot of any mall operator.
What’s Taubman’s niche?
It’s a high-end-mall operator. It owns the Short Hills Mall in New Jersey, Cherry Creek in Denver, and Beverly Center in Los Angeles. Sales growth at Taubman since 2007âand, as you know, we had a little economic hiccup between 2007 and nowâhas been 25% cumulatively, which to me is pretty astounding, because it dwarfs the sales growth that has occurred just about anywhere else. It shows the power of high-end malls, and more importantly from a valuation perspective, it bodes well for cash-flow growth.
What kind of growth could Taubman experience?
We see 13% growth in AFFO this year and 10% next year.
How is it valued?
It trades around $86, which is below our estimate of its net asset value of $88.50. Its AFFO yield for this year is 3.3%, which is lower than the REIT average, but it’s very much in line with the mall average. Given our growth expectations, we think that’s fine.
What’s the upside?
Over the next 12 months, we think REITs will generate a total return of 7% or 8%. For Taubman and the stocks that we feature as Buys, add a few percentage points.
What do you like in apartments?
Equity Residential, Sam Zell’s company. Sam brought it public out of the ashes of the savings-and-loan crisis of the early ’90s, and it’s now the 500-pound gorilla of the sector, with a $38 billion portfolio of apartments. It’s the most efficient operator of apartments, with systems and practices that have been polished and honed for many years. Perhaps most importantly, it can access capital more cheaply than anybody else, especially in the debt markets. The stock seems to have some indigestion from the company’s takeover of the Archstone portfolio, but the company doesn’t. Equity Residential and AvalonBay
[AVB] bought Archstone from the Lehman Brothers estate, and it was a big deal. Equity Residential’s portion was about $9 billion.
Where does the company operate?
Equity Residential has transitioned over the past 10 years from being an owner of a national portfolio to one focused on high-quality properties in key gateway markets like New York, Washington, Boston, Los Angeles, and San Francisco. It should get an extra one or two percentage points a year of growth because those markets are betterâand tougher to build in.
How is it valued?
It’s around $57. Our estimate of NAV is $61. The AFFO yield is 4.3%, which is pretty much on top of the apartment REIT average of 4.4%. So I can buy a best-in-class company at very pedestrian pricing.
By AFFO yield, you are talking about the AFFO in dollars per share divided by the stock price?
The dividend yield is lower than the AFFO yield?
Correct. Most REITs don’t pay out all of their AFFO. Equity Residential’s dividend yield is 3%.
In the office sector, any favorites?
Vornado. Ten or 15 years ago, Vornado was viewed as the best operator in offices. Steve Roth and Mike Fascitelli, the two guys who ran Vornado, generally had the reputation of being the smartest guys in the room. Vornado has made some missteps in recent years, such as its investment in J.C. Penney
. Fascitelli just left, and it’s unclear who’s going to run the company five or 10 years from now. Roth [age 71], who remains chairman, runs it now.
What’s the bull case on Vornado?
While Vornado has had its problems, it hasn’t completely lost its mojo. And Steve Roth is still a very bright guy. Just as importantly, Vornado’s properties are world class. And I like its valuation. It has underperformed the RMS [REIT] index by 13 percentage points over the past 12 months.
How is it valued?
It’s around $87, and we estimate NAV of $89, so it’s another top-tier REIT that trades slightly below NAV. It’s a big Manhattan landlord, particularly around Penn Station.
Is the Penn Station area desirable? It’s not Park Avenue.
It used to be a sort of no-man’s land, but the area is slowly coming into its own. Vornado’s New York portfolio is pretty well positioned. On an AFFO basis, it trades around 4.2%, and that compares with the office REIT average of 3.8%. So on most valuation metrics, it looks pretty cheap, and it’s a high-quality company.
Isn’t Wall Street looking for Vornado to “simplify”?
We think Steve Roth will push forward with some vigor on a simplification strategy. It isn’t necessarily in his nature, but we think he is committed to it. Two years from now, it will be a much easier story for investors to understand and appreciate.
One emerging trend is REITs backed by single-family homes. What do you think?
We’re certainly going to see an awful lot of activity here. The platforms that are being built, and the portfolios being cobbled together are becoming quite large and in some cases pretty impressive. And the sponsorship behind some of them is also impressive.
How many are public now?
The only pure play was Silver Bay Realty Trust
[SBY]. Another, American Residential Properties
[ARPI], just went public. Colony Capital is a well-regarded sponsor, and it just filed for an initial public offering of Colony America Homes. Blackstone currently owns $4 billion worth of houses. They want to get that number above $5 billion, which it will probably be by next year, and then they’ll take it public. And Wayne Hughes, the founder of Public Storage, is also in this business.
How much activity could there be?
Over the course of the next year or two, we expect to see multiple IPOs and many billions of dollars of single-family housing come public as REITs. At this stage, we still are grappling with the economics of it. There is still an awful lot we have to learn, and I think even the sponsors have to learn, because nobody’s been in this business very long.
As best we understand it, you can buy homes in a lot of Sun Belt markets, and elsewhere, and get a fully loaded yield prior to capital expenditures, somewhere in the 6% ballpark. If you throw in a capex reserve, it may take the yield down to 5%.
What are the economics of the business?
They’re uncertain. But if I can buy homes at an all-in yield of close to 5%, and then play the appreciation trade, which given the direction of housing, and given how far it might come back, we think it’s going to be a product that will be well received by the public market.
Do the sponsors want to be in the game for the long term?
These companies are building platforms to operate these properties as continuing businesses. They aren’t designed to play the flip trade. It remains to be seen how successful anybody can be, but I wouldn’t be surprised if some of these IPOs are successful out of chute.
Equity Residential / EQR
Taubman Centers / TCO
Vornado Realty / VNO
|*Returns include dividends **Based on adjusted funds from operations (AFFO) E=Estimate Source: Thomson Reuters