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Time to Get Into REITs?

Real estate investment trusts (REITs) have been among the best investments over the past decade.
 
Last year, US listed equity REITs surged 31.58 percent, compared with 10.88 percent for the S&P 500 and 18.33 percent for the Russell 2000, according to the National Association of Real Estate Investment Trusts (NAREIT).
 
Equity REITs easily outperformed the S&P, Russell 2000, Nasdaq Composite and Dow Jones Industrials over the most recent three-year and five-year periods. In fact, over the past 10 years, REITs beat all of these benchmarks, except for the Nasdaq Composite, which compounded at a 17.62 percent annualized rate versus 16.15 percent for the REITs, according to NAREIT.
 
However, in the past month alone, REIT stock prices have fallen from 7 percent to 10 percent, according to Arthur Oduma, senior equity analyst with Morningstar.
 
So, the question is whether the long bull market is over for REITS or now is a good time to get in.
 
REITs are companies that own and most often actively manage income-generating commercial real estate. Some REITs make or invest in loans and other obligations that are secured by real estate collateral. Most REITs are publicly traded.
 
REITs are required to distribute at least 90 percent of their taxable income to shareholders annually in the form of dividends. Significantly higher than other equities on average, the industry's dividend yields generally produce a steady stream of income through all market conditions.
 
Until recently, REITs benefited from cheap financing, which fueled a blistering real estate boom, and low interest rates, making their relatively high payouts very attractive compared with fixed-income investments.
 
However, Oduma notes, "With the Fed raising rates, a lot of people believe fixed income is better than the REIT dividend yield. This is driving out money." 

 He notes that the average dividend yield on property REITs is currently 4.8 percent versus around 4.3 percent to 4.4 percent for 10-year notes. So, the 40-point risk premium for REITs doesn't seem so attractive.
 
Merrill Lynch analyst Steve Sakwa notes this premium is below the long-term average of 115 basis points and even the 92 basis-point spread over the last two years. "This simple valuation tool suggests that a further backup in long-term interest rates could pressure REIT stocks by pushing up the sector's divided yield," he adds in a recent report.

He says that based on a number of valuation metrics, including yield spreads, cash flow multiples, and price-to-NAV ratios, the REIT sector could experience an additional 5 percent to 10 percent pullback if the yield on the 10-year Treasury reached 5 percent.

What's more, the average price-to-AFFO (adjusted funds from operations)-a key valuation metric--is currently 18.8 times on a forward 12-month basis, Sakwa points out. This compares to the sector's long-term average of 12.1 times and the all-time high of 20.8 times

On the other hand, the average price-to-NAV is only 97 percent versus the long-term average of 103 percent, which means that the stocks are trading at a slight discount to their private market values, the Merrill analyst stresses.