Reprinted by permission from REIT Wrap Special Report, June 24, 2010
By David Shulman
This month’s column won’t win me the “Mr. Congeniality” award. As those who have followed my work over the years will attest—this is nothing new.
What I will outline below is my view that relative to stocks, REITs and for that matter real estate, look very over-priced. This cannot persist long-term!
History suggests that in recoveries from structural bear markets, the previous bull market leaders tend to significantly lag after an initial rally. For instance, the tepid performance of technology stocks, the bull market leadership of the 1990s, over the past decade. As a result, today, tech stocks look cheap compared to real estate.
At this month’s NAREIT meeting in Chicago Sam Zell told the audience that “a REIT is a stock, first last and always.” Like stocks in general REITs respond to broad macroeconomic and industry specific fundamentals and are valued by stock market metrics.
Try as NAREIT would like to compare REITs with real estate, every trading day the shares are evaluated by stock investors in general not just investors seeking a real estate proxy. As a matter of fact this behavior is exactly what many of the pioneers of the modern REIT era had hoped for.
Because, REITs do not trade in their own real estate-centric cul-de-sac, they are continuously compared to other sectors of the stock market and by the normal metrics of stock market valuation REITs appear to be especially over-priced.
According to data compiled by Michael Bilerman’s team at Citigroup REITs are trading at a weighted average FFO multiple of 15.3X on 2010 estimates. As we all know, FFO is not a normal stock market metric, in fact it an alien measure so here we will use some common equity valuation measures that are also suitable for REITs.
Two appropriate measures would be free cash flow yields to equity (net income per share plus depreciation minus capital expenditures and incremental working capital requirements/equity market capitalization which is analogous to Reitland’s AFFO yield) and EBITDA multiples (Enterprise Value/EBITDA). By these metrics REITs are currently trading at an estimated 5.1% free cash flow yield based on 2010 estimates and 16.6X latest quarter EBITDA run rate.
By comparison the broader market, according to Goldman Sachs, is trading at a 7.0% free cash flow yield 7.9X EBITDA based on consensus estimates for 2010. On average, then, corporate equity returns about 40% more free cash per dollar invested than REITs and trades at half the EBITDA multiple.Further free cash flow in the corporate sector is after research and growth capital expenditures, while the estimate of AFFO only subtracts maintenance capital expenditures.
In order to better make my point let’s compare the valuation metrics for several of the leading REITs and compare them with well known industrial companies. Put bluntly the valuation differences are stark. By way of reference I have included an estimate for unleveraged physical real estate assuming a 7% cap rate, 50 basis points of management fees and 100 basis points for capital expenditures.
Below are the estimated 2010 free cash flow yields and EBITDA multiples for the selected REITs followed by an estimate for physical real estate and then the data for the selected industrial companies. Notice that my list of industrials includes such premier growth companies as Apple Computer (AAPL) and Google (GOOG). The data for the REITs are from Citi. The data for the industrial companies come from multiple sources, largely Factset and my own calculations.
AvalonBay (AVB) 3.2%, 24.8X
Equity Residential (EQR) 4.0%, 19.9X
Simon Property Group (SPG) 4.9%, 16.4X
Regency Centers (REG) 4.7%, 15.4X
Boston Properties (BXP) 3.5%, 16.7X
Vornado (VNO) 4.2%, 17.0X
AMB Property (AMB) 3.7%, 18.6X
Public Storage (PSA) 5.1%, 16.2X
Ventas (VTR) 5.4%, 16.5X
Physical Real Estate @7% cap rate 5.5%, 15.4X
Apple Computer (AAPL) 4.7%, 14.3X
Google (GOOG) 5.6%, 12.8X
Microsoft (MSFT) 8.2%, 7.9X
Abbott Laboratories (ABT) 9.0%, 9.4X
Johnson & Johnson (JNJ) 8.2%, 8.0X
Emerson Electric (EMR) 5.1%, 10.4X
Illinois Tool Works ( 8.2%, 11.3X
3M (MMM) 7.0%, 8.8X
Coca Cola (KO) 6.0%, 12.3X
Procter & Gamble (PG) 6.1%, 10.2X
Exxon Mobil (XOM) 5.5%, 7.2X
Chevron (CVX) 6.2%, 4.9X
The data clearly suggest that investors value one dollar of real estate cash flow far more than one dollar of corporate cash flow. In fact AvalonBay is way more expensive than Apple Computer and Google looks real cheap relative to all of the REITs!!! Furthermore Abbott Laboratories, Johnson & Johnson and Microsoft have free cash flow yields in excess of 8%, 60% higher than the average REIT. From a valuation perspective either both real estate and REITs are extraordinarily expensive or that stocks, in general, are a super bargain.
This discrepancy in valuation may not mean all that much to a dedicated REIT manager who is required to invest in the real estate space, but to a diversified manager of equities and to an asset allocator the valuation differences have to be troubling.
To be fair the markets could be signaling that in the years to come real estate cash flows will be far more durable than corporate cash flows. That certainly is possible, but as we have seen over the past few years the real estate economy seems to be inexorably linked to the overall economy. It is, therefore, hard to imagine a weak corporate profit environment being a good thing for real estate demand. Moreover should the current monetary and fiscal policies lead to a significant inflation later in the decade, the extraordinarily low interest rates we are now experiencing will become a thing of the past. In that environment the low 5%-7% cap rates of recent years could very well revert to the more normal 8% to 10% range.
Yes, real estate cash flows could very well outperform corporate cash flows in a more inflationary environment as depreciation allowances prove to be inadequate to replace equipment. During the inflationary 1970s corporate cash flow lagged well behind net income as the cost of replacing inventory and equipment at higher and higher levels became a very real drain on cash flow. It was in that environment where real estate cash flows proved themselves to the broad investing community. Are we going back to that world? Not likely in my opinion.
Alternatively most investors believe that the real growth in the global economy over the next decade will take place outside of the United States. It is, therefore, improbable that domestic real estate cash flows will outperform the cash flows being derived from the global corporations listed above which leaves me hard pressed to explain the valuation differences.
Simply put at current prices, non-REITs appear much more attractive than domestic real estate and REITs and because REITs are generally trading at premiums to their underlying real estate value, look even more expensive.
David Shulman was formerly the Senior REIT Analyst at Lehman Brothers. Heis now affiliated with Baruch College, the University of Wisconsin and theUCLA Anderson Forecast. He can be contacted at:firstname.lastname@example.org