REITs vs. Commons
Board: Real Estate Investment Trusts
It's been a relatively slow week here at the Board, with few new topics for me to spout off on. I know less about Singapore REITs than Riley and Kacie know about quantum physics. So, please allow me to copy and paste a post I did this past week for SNL. It discusses the difficulty of comparing the valuations of REIT stocks with the valuations of other stocks - unfortunately, it's too often like comparing apples to kidney beans. It also ponders the "right" weighting of REIT stocks within a diversified investment portfolio.
SURE, REITS ARE STOCKS, BUT…
Please eavesdrop with me on a brief conversation between Riley and Kacie, my Golden Retrievers, as they consider whether REITs can be fairly compared with other stocks, and their role in a diversified investment portfolio.
Kacie: A friend of mine has his investments managed by a well-known and highly-respected investment manager, who has placed only 2% of his assets in REITs. The manager claims that REIT stocks are “expensive.”
Riley: On what basis?
Kacie: Not sure, but he said something about REIT earnings multiples being over 20x, compared with PEs averaging 15x for non-REIT stocks.
Riley: Well, first of all, comparing AFFO multiples to earnings multiples is like comparing a beef bone to Mother Hubbard’s doggie biscuits. They are both “food,” but of very different types. To make a fair comparison, you’d need to figure out non-REITs’ free cash flows to arrive at an equivalent “AFFO multiple” for them. And doing that is even more difficult than catching a speeding car; we don’t know from year to year how much of its cash flow a business must deploy to remain competitive. Some businesses are cash cows, some are cash hogs, and these can change almost overnight in response to changing market conditions, the competition, technology inroads, etc.
Kacie: If we cannot easily compare REIT to non-REIT stocks on the basis of earnings multiples, how about looking at intrinsic values?
Riley: Again, that’s easier said than done. We can approximate intrinsic values for REIT stocks by valuing their properties (using appropriate cap rates obtained by looking at recent sales prices for comparable properties in comparable markets), adding some value for non-real estate businesses, land and pending development projects, and subtracting debts and other obligations. But how does anyone determine “intrinsic value” for a non-REIT business?
Sure, you can project earnings and free cash flow over a number of years (using only this or next year’s earnings is a worthless exercise), and discount those amounts to net present value. But, for the vast majority of businesses, those projections will be as reliable as predictions for Best in Show at the next Westminster Kennel Club event. In case you haven’t noticed, my fuzzy friend, competition is fierce across the globe, and future earnings are highly dependent upon rapidly-changing revenue growth rates, profit margins, competitive conditions and new technologies.
Kacie: OK, then, if we cannot reasonably determine if REIT stocks are cheap or expensive relative to non-REIT stocks, how does an intelligent investment manager decide how to weight REITs in a balanced investment portfolio?
Riley: I am skeptical that portfolio allocations can be made on the basis of correlations, standard deviations and volatility metrics. REIT stocks’ correlations with non-REIT stocks have been all over the park, standard deviations work until they don’t, and short-term volatility of REIT stocks will rise and fall on the whims of hedgies and other fast-money players.
Kacie: There must be a better way.
Riley: A “better way” is to determine the investor’s investment time horizon and tolerance for risk (defined as permanent loss of capital, not trading volatility), and to invest in REITs accordingly. Look, over short time periods REIT stocks can bounce around like that Miniature Pincher down the street. But if the client has a longer term time horizon, it’s essential to remember that REITs’ cash flows, derived in most property sectors from long-term leases, are stable and predictable; REIT stocks are somewhat bond-like.
And, although there are unusual periods when property values can gyrate wildly, as from 2007 through 2009, property values and REIT NAVs – which underpin REIT stock values – are very stable. Businesses and consumers need space in which to live, work and play, and thus there will always be demand for the products and services that REIT organizations sell via their properties and property management. And while obsolescence cannot be ignored, there are few new trends, resulting from changing technology or life-styles, that will quickly erode the value of a good piece of commercial real estate.
Kacie: So how does all this translate into a portfolio allocation for REIT stocks?
Riley: It’s quite simple, really. If the investor is highly averse to short-term volatility, or wants to hit doubles, triples and the occasional home-run, he or she should have a very modest REIT allocation. But, otherwise, a very substantial allocation to REIT shares is certainly warranted. If we don’t know that, we’ve learned nothing over the past 40+ years of REITs’ existence. REITs are the singles-hitter’s sweet spot, especially when the investment time horizon is reasonably long.
Returns will be pretty good (albeit less than the double-digit returns REIT investors have enjoyed over many prior periods), and true risk is modest. There will be a few dogs in every REIT portfolio – sorry, Kacie – but a well-diversified assortment of REITs in all property sectors will perform quite well over time. History has proven that.
Kacie: Well, then, should investors put 10% of their funds into REITs? 20%? 50%?
Riley: How long is a string? Pick a number. I am comfortable with a REIT allocation of as much as 50%, but that’s just me – an old dog who doesn’t like to take a lot of risk, but willing to accept unwarranted – albeit sometimes real – short-term price volatility. Prior NAREIT studies have suggested 20% for the “typical” investor, and investment guru David Swensen (of Yale Endowment fame) has suggested a similar number. Others, such as William Bernstein, have suggested much less. See, for example, http://www.bogleheads.org/wiki/Lazy_Portfolios My personal belief is that any conservative investor with a REIT allocation of below 15-20% just isn’t playing with a round tennis ball.