The disappointing ADP employment report was the big buzz this morning. But I always have the same advice when it comes to this number: Ignore it. Whatever happens as a result of traders developing an opinion on ADP's numbers can be completely undone by Friday's jobs report. The other developing topic was the growing disconnect between real estate investment trust (REIT) valuations, actual property values and anything resembling common sense real estate investing. No one with an ounce of knowledge about property markets would pay the multiples or accept the yields offered by the large-cap REITs right now.
The apartment sector really jumps out as having disconnected values. When I look at the largest REIT in the sector, I see that Equity Residential (EQR) is yielding just a little above 2%. If I look at its latest earnings report and add a few somewhat aggressive growth assumptions, the company could produce funds from operations of about $800 million this year. In my somewhat limited brain, this means that the absolute most this company is worth is roughly $8 billion to a smart investor. The enterprise value is a whopping $27 billion. The shares fetch more than 3x the equity value of the properties in the portfolio. This company owns great properties and has excellent management but at the end of the day, the price is far too high for a rational long-term investor. Most of the other apartments REITs are similarly priced as investors have flocked to exploit the trend of post crisis rental housing. It is a great theme, but you are paying far too much for the idea.
I was surprised to find that the disconnect exists in what should be the weakest segment of the real estate markets. The consumer is a little healthier than in the past few years, but retail is still not even close to fully recovered. Even the premier shopping malls and centers still have vacancies and rents are slow to rise. I have spotted some small retail REITs that were very cheap, including Kite Realty Group (KRG) and Cedar Realty (CDR), but the larger ones show what I think is gross overvaluation.
Look at Simon Property Group (SPG). Using its latest quarterly results and management's guidance, I can see optimistic funds from operations of about $2.5 billion. In my mind, that makes the maximum price for a rational investor $25 billion for the regional mall and outlet center operator. Its market cap is $47 billion and the total enterprise value is almost $65 billion. The common stock is valued at 10x the book value of the equity in the properties. The shares yield a miniscule 2.4%. Once again, this is a very well-run company with some great properties but the asking price is simply too high for a long-term investor to even consider.
The REIT sector is showing a disconnect not just between stock market and property values but there is also a disconnect between large REITs and the smaller ones. I blame a lot of this on ETF trading and asset allocation. Large funds looking to allocate capital to what appears to be an undervalued sector are pushing money toward the largest and more liquid names. They are not evaluating the valuation of the property portfolio or cash returns from dividends -- instead, they just push money into the real estate classification on the mistaken assumption that it is all the same. Clearly, the valuation disconnect is indicating that it is not.
ETF trading makes the disconnect between REITs and real property valuations even worse. Very few traders who buy shares of the real estate ETFs such as the Dow Jones iShares Real Estate ETF (IYR) put much thought into the valuation of the underlying real estate valuations. Simon Properties and Equity Residential are two of the largest holdings of the fund because the fund managers need the more liquid names to have a liquid trading vehicle. I venture a guess that none of the investors in the leveraged real estate ETFs such as ProShares Ultra Real Estate (URE) thought about valuation for so much as a second. They just wanted exposure to a group their trading system likes today. However, their buying pushes up the valuation of the more liquid REITs and widens the disconnect.
I love real estate as a long-term investment. Out here in the real world, most properties are still cheap and have significant recovery potential for patient investors. Some smaller REITs can give us a chance to invest in the real estate opportunity; however, short-term trading and liquidity-driven asset allocation choices make the larger REITs too expensive at current levels.
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