REITs - Real Estate Investment Trusts - Info &amp; Discussion

REITs vs S&P 500 (3 month chart)

Top 261. May 6, 2005 10:39 AM

» bob90245 - Re: REITs Still Outperforming

In response to REITs Still Outperforming posted by honeyoneohone:

You're right! REITs and the S&P 500 were neck and neck during Feb-Mar. In April, REITs pulled away from the pack. Still, this horse race isn't over by a long shot. See you at the finish line in December. <img src=http://www.suite101.com/images/emoteicon...>

-- posted by bob90245

http://www.marketwatch.com/news/print_st...

Top 262. May 24, 2005 5:02 PM

» honeyoneohone - REITs: Goldilocks or Not?

.
Merrill's valuation call on six REITs

By Mark Cotton, MarketWatch
Last Update: 4:06 PM ET May 24, 2005

NEW YORK (MarketWatch) -- Merrill Lynch downgraded six real estate investment trusts on valuation grounds Tuesday, saying the outlook for the sector is dependent on the pace of economic growth and the future course of long-term interest rates.

"Our biggest concern is that investors are not pricing risk into the REIT sector and assume that the goldilocks environment -- modest gross domestic product growth coupled with low interest rates -- will continue in perpetuity," said analyst Steve Sakwa.

All six stocks, which were cut to neutral from buy ended lower on the day: Kilroy Realty Corp. (KRC: news, chart, profile) was down 0.9% at $46.06; Boston Properties Inc. (BXP: news, chart, profile) fell 2.1% to $66.80; Simon Property Group Inc. (SPG: news, chart, profile) dropped 1.6% to $68.89; General Growth Properties Inc. (GGP: news, chart, profile) was off 2.1% at $39.04; Pan Pacific Retail Properties Inc. (PNP: news, chart, profile) slipped 1.6% to $64.10, and Regency Centers Corp. (REG: news, chart, profile) fell 2.5% to $55.04.

Sakwa said the downgrades reflect, more than any concern over deteriorating company fundamentals, sharp appreciation in the sector's stock prices over the last two months.

The analyst says REITs have become expensive relative to bonds and equities, noting that the Amex Morgan Stanley Reit index (RMS: news, chart, profile) , which tracks the sector, has risen nearly 13% in the last two months while the S&P 500 Index ($SPX: news, chart, profile) has declined 1%.

"The only metric where REITs do not appear expensive is versus the private market, which continues to experience strong trends in pricing on asset sales due to the low interest rate environment," said Sakwa.

Yet it's prospects for the durability of this low rate environment that leads Sakwa to be more cautious on the sector.

He says that the REIT sector could rise a further 2% over the next 12 months if the yield on the benchmark 10-year Treasury note remains at 4.05% but that it could fall as much as 8% if it rises to 4.6% over the next year.

For Sakwa, the sector is caught between a rock and a hard place.

If the recent slowdown in the economy proves to be just temporary, any pick-up in growth will likely send long-term interest rates higher, hitting valuations.

"On the other hand, if economic growth is decelerating then demand for real estate should slow later this year and into 2006," which would put the sector's earnings at risk, said Sakwa.

-- posted by honeyoneohone

Top 263. May 24, 2005 7:07 PM

» Kirk - VGSIX vs SnP500 YTD

In response to REITs Still Outperforming posted by honeyoneohone:

REITs Still Outperforming

Here I’ve added Vanguard International, VGTSX, and the home building sector, HOM, for an interesting perspective.
<img width=452 height=366 src=http://www.marketwatch.com/charts/int-ad... >

-- posted by Kirk

Top 264. May 25, 2005 10:14 AM

» Normxxx - Re: VGSIX vs SnP500 YTD

In response to VGSIX vs SnP500 YTD posted by Kirk:

REITs will track the RE market.

-- posted by Normxxx

Top 265. May 25, 2005 12:10 PM

» Normxxx - The outlook for REIT ETFs (IYR, RWR, VNQ)

I stand corrected! I guess REITs follow the interest rate/dividend rate curves.

The outlook for REIT ETFs (IYR, RWR, VNQ)

By J.D. Steinhilber | 25 May 2005

Interesting analysis of REITs as an asset class by J.D. Steinhilber, founder of ETF newsletter and investment management firm Agile Investing. The currently available REIT ETFs are IYR, RWR and VNQ. He writes:

The combination of below-average spreads to 10-Year Treasuries and our outlook for rising 10-Year Treasury yields results in a decidedly cautious assessment of REITs. As of the end of Q1, REIT prices have declined approximately 6% from the start of the year; but remain vulnerable to further correction, especially if bond yields move higher as we expect.

REIT Analysis:

Chart A: REIT yields have fallen in parallel with Treasury yields over the past five years. (Click on charts to enlarge size.)

Chart B: Although it is moving up from the lows reached in late 2004, the spread between the REIT yield and the 10-year Treasury yield is still well below the longer-term average of 1.6%. The combination of a below average spread to 10-Year Treasuries and our outlook for rising 10-Year Treasury yields results in a decidedly cautious assessment of REITs.

Chart C: REITs look particularly overvalued relative to the S&P 500 with the yield spread of REITs to the S&P 500 dividend yield near historic lows.

The contents of this letter/report does not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of this message is not to be construed as constituting market or investment advice. It is intended for educational purposes only. Individuals should consult with their own advisors for specific investment advice.

-- posted by Normxxx

Top 266. May 27, 2005 3:27 PM

» scottw57 - Bad decision on cutting your reit position last year

In response to Re: Re: Re: Re: oops, there goes my REIT posted by Normxxx:

-- posted by scottw57

Top 267. May 27, 2005 4:36 PM

» Normxxx - Re: Bad decision on cutting your reit position last year

In response to Bad decision on cutting your reit position last year posted by scottw57:

Probably. But only SPG (of my basket) has really outperformed since then. And I have to go with the odds (see my post above). In the long run, what goes up, must come down-- and I think maybe RE will come down next year. We have predictions on this BB of interest rates going to 2%-- if so, REITs will really shine; but if they go the other way, watch out.

-- posted by Normxxx

Top 268. Aug 2, 2005 12:06 PM

» Normxxx - Better Way to Value REITs

A Better Way to Value REITs

By Craig Woker, Morningstar.com | 2 August 2005

For years, a fierce debate has raged among fundamental investors who follow property companies over the best way to value these unusual entities, most of which are known as real estate investment trusts, or REITs.

The battle has been pitched between two camps. On one side, the vast majority of REIT investors have relied almost exclusively on the net-asset value (NAV) model, which I've written about in the past. The idea behind this model is that a REIT is worth no more or less than the value of the buildings that it owns minus the debt that it owes. To estimate the value of the REIT, investors simply estimate the rental income the firm can earn over the coming year and divide by a discount rate, known as the "cap rate." In this valuation approach, the company is worth just as much dead as it is alive, liquidated versus a going entity. In the other camp, a much smaller minority of investors relied on some sort of discounted cash-flow model. The idea here is that a REIT stock--like any other investment--is ultimately worth the sum total of its future cash flows, discounted back to the present.

Thus, the debate over how to value REITs has hinged on one major idea: Should investors value the buildings (NAV) or the earnings (discounted cash-flow)? In other words, can active REIT managers add value to the firms that they're running? Or, when investors sink money into a REIT stock, are they buying nothing more than plots of land and some boxes of bricks?

Today, we declare the debate over. The discounted cash-flow method is superior.

We're very excited to announce that we've rolled out a new discounted cash-flow model to value all of the property REITs that we cover, and that we've ceased using our old NAV model to generate fair value estimates for these firms. As a result, you'll notice a lot of valuation changes on our site today. This move impacts 61 property REITs that Morningstar covers.

Fair Value Estimate Upgrades
The difference between our old fair value estimates and the new values can be startlingly large. Across the board, our REIT fair value estimates have jumped about 18% on average. But averages mask the wide range of changes occurring on a company-by-company basis. In some instances— like General Growth GGP— our estimates are up 80% or more. Meanwhile, we've lowered our valuation for certain firms, such as BRE Properties BRE.

There are countless reasons we believe a discounted cash-flow approach is superior to NAV. But, ultimately, our decision to head in this direction came down to a few major factors:

REIT managers can create or destroy value for shareholders as a result of their actions.

Because of this, REITs with good management teams— those capable of generating returns in excess of the REIT's cost of capital— will trade at levels above the net asset value of the firm.

Cash flows and earnings ultimately drive the value of the stock in a real estate firm— just as they drive the value of any other stock.

Intuitively, this makes sense. Just as Microsoft MSFT or General Electric GE trade for multiples well in excess of their book value, so too can REITs trade above or below their net asset values, depending on the actions of their managers.

The challenge lies in quantifying this performance. To do so, we settled on a measure that we've dubbed "return on real estate assets"— or ROREA— which is used to measure the amount of cash flow a firm generates relative to the real estate assets it owns. This sounds complex, but the core concept behind it is quite simple, and is similar to better-known measures like return on equity (ROE) or return on invested capital (ROIC). In all three cases— ROREA, ROE, and ROIC— we're simply trying to measure how much cash or earnings a company can spit off relative to how much capital it has. The most desirable businesses throw off tons of cash with as little invested in the business as possible.

Measuring Success
Our research not only showed that a REIT can create value by earning returns above its cost of capital, but we also found strong evidence that this superior cash-flow generation has already driven returns for investors through higher stock prices and growing dividends. For instance, if we divide the firms in our REIT coverage list into two halves based on ROREA, the top half generated a compound annual return to shareholders of 25.8% per year over the past five years versus 19.2% per year for the bottom half. The difference is even more marked when looking at the true creme de la creme. The top quartile of firms, as ranked by ROREA, offered a compound annual return to shareholders of 29.3% per year on average over the past five years versus just 16% for the bottom quartile. As confirmation of these results, if you look at things in a slightly different fashion— growth in book value per share— similar results are attained. After adjusting for differing dividend policies, REITs that were better at compounding book value (a byproduct of superior earnings) delivered far greater returns for investors.

It's also very clear that the stock market cares about the cash flows and profits received from a REIT investment— not just the value of the buildings.

Tough to Create Wealth
That said, it's no easy task for REIT managers to add value. On the whole, their actions and other intangibles that a firm might have account for a small percentage of the overall value of these firms, compared with other industries. We can gauge this by comparing our discounted cash-flow values, which measure the value of the full enterprise (buildings, management, and other earnings streams), with current NAVs, which estimate the value only of the buildings. In most instances, management decisions and these other intangibles account for only about 15%-25% of the overall value of the stock.

This is not a knock on the hard work that many REIT managers undertake. Rather, this reflects that REITs' buildings have a tremendous amount of intrinsic value, regardless of who happens to manage them. This is the reason that investors depended on NAVs historically. In contrast, the tangible assets of a software company or a drug firm are worth very little.

Additionally, REITs face unique regulatory constraints. For instance, these companies are very limited in the businesses that they can pursue, with federal regulations requiring the vast majority of income to come from properties or a handful of other assets. Plus, REITs must pay out most of their income in dividends, limiting reinvestment opportunities.

Roads to Success
Despite these constraints, we found that there were five major ways in which REIT managers could boost the overall value of their firm, and integrated these value drivers into our DCF model. First, REITs can focus on boosting earnings from their existing portfolio. Simon Property Group SPG, a leading mall REIT, is an excellent example of this. Even as more retailers have moved away from malls and consumers have begun shopping more on the Internet, Simon has boosted its rental income substantially, charging 20% more on new leases than it did on expiring leases year after year and filling its malls with high-margin revenue sources like advertising and kiosks.

A second way that REITs can add value for shareholders is by increasing the portfolio externally, often through "capital recycling." In particular, this can be accomplished by purchasing undervalued properties that can be developed or redeveloped into a higher-productivity asset. Vornado VNO is an example of a company that creates value this way; the firm has an exceptional track record of seeking out "real estate plays."

A third way that a REIT can boost its value is by expanding into property asset management, usually through joint ventures. In these arrangements, the REIT partners with another group— usually a pension fund— to jointly own a property, with the REIT taking a minority stake, say of 20%. The REIT then pockets a stream of high-margin fees, with little capital requirements, to manage the assets. Taubman TCO is an example of a company pursuing this strategy.

A fourth value-creating strategy is broadly known as "financial engineering," a catch-all phrase for other balance-sheet maneuvers REITs can undertake, such as cutting debt costs, seeking out tax-free property exchanges, buying low-cost options on properties, and so forth. Most REITs seek financial engineering opportunities wherever possible.

The final way that REITs can add value for shareholders is to retain earnings and reinvest the funds at above-average returns. After all, if a REIT has access to investments in the private real estate market that can generate a 15% per year return, and investors' required return in the stock market is only 10%, then this is a value-adding activity for shareholders. Predicting who will be the best investors in the future is no small task. However, just as investors can look at the track records of mutual fund managers to gauge their investment track record, so too can REIT investors consider managers' track record at investing in good projects above the REIT's cost of capital. Alexandria ARE, Ventas VTR, and Universal Health Realty UHT have been good performers over the past five years, and you'll find other firms noted in our REIT reports.

Building discounted cash-flow models for REITs requires significantly more work; these models require literally hundreds of inputs, compared with a NAV model, which is a basic valuation tool requiring little more than assumptions about next year's operating income and the cap rate. But we feel that this additional detail is very important and will ultimately help us better select appropriate investments to recommend. In little more than two years, we have greatly expanded the breadth of our REIT coverage. We started with basically no REITs under coverage just a short time ago, and now there are few other research shops that provide coverage on as many REITs as we do. With this breadth, the next logical step was to deepen our coverage, and discover new insights into the REITs we cover.

Real Estate Bubble?
Since REITs have been one of the hottest sectors of the stock market the past five years, it's not entirely surprising that these stocks are trading at premiums to our fair value estimates. REITs on average have generated a compound annual return of 20%, by some measures, and the cash flows for commercial space— whether offices, industrial properties, shopping centers, or hospitals— simply do not support these values, even after we add in all the things that management can do to boost returns.

Is there a "bubble" in the national housing market? Our discounted cash-flow work further supports the thesis that houses— or at least condos— have reached overheated prices. There's only a handful of REITs that we believe are worth less under the discounted cash-flow approach than under the NAV. But the three firms with the biggest drops in fair value all run apartment complexes: Equity Residential EQR, BRE Properties and Apartment Investment and Management AIV. What's the reason for this? Apartments are fetching such high prices as condo conversions that it's highly unlikely that these firms can generate enough cash flows from the properties they own— or through other efforts of management— to justify not liquidating their balance sheets. We've given apartment firms some credit for the steps they are taking to sell off properties at high market prices, but none so far have announced plans to sell off every last unit and ride off into the sunset.

We're thrilled to roll out this new REIT model and are excited about the insights we've already been able to glean from this work. We look forward to bringing you further insight in our REIT analyses in the years to come.

The contents of this letter/report does not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

-- posted by Normxxx

Top 269. Aug 6, 2005 10:48 AM

» Normxxx - The Other RE Bubble

Pop!
The Other Real-Estate Bubble

By ANDREW BARY, Barron's | 6 August 2005

<img Align="Left" hspace="10" vspace="5" src="http://online.barrons.com/public/resourc...">THE NATIONWIDE INFATUATION with property has spilled over into the stock market, where shares of real-estate investment trusts have soared, despite spotty operating results and higher interest rates.

The run-up in REIT shares, which have doubled since early 2003, has raised concern on Wall Street that a bubble could be forming in the $300 billion sector. "Our view is that valuations are in uncharted territory, and the group is very susceptible to a correction," says Jonathan Litt, the REIT analyst at Smith Barney. What's the downside? Litt says that shares of real-estate investment trusts could fall more than 10%.

[Normxxx Here: Make that 50% in any kind of market downturn and/or RE slowdown. ]

This year, the major REIT indexes are up about 10% (including dividends) after 30%-plus returns in both 2003 and 2004.

Some cracks may be starting to form in the REIT sector. The group declined 2% Thursday and was down about 3% Friday, hurt by a setback in the bond market that followed the release of stronger-than-expected July employment data Friday morning.

The two-day selloff illustrates the [current] volatility in REIT stocks. Morgan Stanley's REIT index, for instance, dropped 10% in January and had rallied 25% from late March until the middle of last week. Still, REITs often appeal to risk-averse investors who [haven't caught on to the new volatility].

Litt acknowledges that a sustained REIT retreat might not come soon because "a wall of money" continues to chase the sector and the entire U.S. commercial property market in which the group invests.

[Normxxx Here: Danger, Will Robinson! Danger! The hedge funds have taken to 'investing' in 'selected' REITs— and I try not to invest in any narrow market frequented by hedge funds! ]

What could derail the REITs? Further interest-rate increases, a bursting of the property bubble, a slowing economy or a shift in investor preference toward common stocks.

Danger signs abound. The group, which offered dividend yields of 8.75% in late 1999, now has an average yield around 4.5%. Some leading REITs, including Vornado Realty Trust, Simon Property Group, General Growth Properties, Boston Properties and Public Storage, yield less than 4%— comparable to the rate on risk-free T-bills. The low REIT yields mean the sector is far less defensive than it used to be.

REITs look pricey based on virtually every historical financial metric: dividends, dividend yields relative to Treasury rates, and various earnings measures, including funds from operations, or FFO, and adjusted funds from operations, or AFFO. In fact, REIT dividend yields are at a 30-year low. And one measure of REIT's attractiveness— their yields minus Treasury-bond yields— is close to zero for the first time in seven years.

The REIT run-up has generated less attention than the surging prices of homes throughout the country. REITs don't own single-family homes, but they do control office buildings, apartment complexes, shopping centers, warehouses, storage facilities and other types of income-producing properties. The three biggest sectors are apartments, malls and office buildings. There are nearly 200 publicly traded realty trusts.

REIT INVESTORS HAVE SEEMED unconcerned about rising yields on Treasury paper, including the move in the benchmark 10-year T-note to 4.4% from a June low of 3.9%. As income vehicles, real-estate investment trusts become less attractive when yields on alternative investments move up. Short-term bond rates, now at 3.25%, probably are heading to 4%. That could hurt realty trusts that rely on floating-rate debt.

"There has been an enormous demand for yield and enormous demand for real cash income," says Greg Whyte, a REIT analyst at Morgan Stanley. "A lot of people are surprised at the amount of money chasing real-estate assets and REIT stocks."

[Normxxx Here: Read: Hedge Funds! ]

Where there once were three to five bidders for a $1 billion "trophy" commercial property, now there could be 20 or more.

Many Street analysts, including Litt and Whyte, have underestimated the power of the REIT rally. Earlier this year, one of the most prominent bears, David Shulman retired as the senior REIT analyst at Lehman Brothers. Shulman then was teased by Steve Roth, the influential and outspoken chief executive of Vornado Realty, one of the biggest owners of office buildings in Manhattan. Roth wrote in Vornado's annual report: "What can I say to my dear friend David, who has an IQ of 250 and had a three-year sell on Vornado with a $43 average target. I'm sorry, David. I just couldn't resist." Vornado now trades at 85.

The upside potential in REITs may be limited, barring a drop in long-term rates. REIT profits are rising, but outside the hot shopping-mall sector, the gains haven't been large. Profit growth could run at 6% to 7% annually in the coming years, barring an economic downturn.

OFFICE REITS CONTINUE to contend with the expiration of leases signed at high rents in 1999 and 2000. Another problem: continued corporate consolidation, which has hurt markets like Boston, where such big hometown employers as FleetBoston Financial, John Hancock and Gillette have been taken over. Apartment REITs are only starting to recover after a tough stretch in which occupancy and rents were pressured by the growing trend toward home ownership.

"REITs are being priced for perfection," says Peter Siris, who heads Guerrilla Capital, a New York investment firm. "REITs have benefited because the economy has stayed strong while rates haven't gone up. But I don't think you're going to have a decent consumer economy and lower rates forever." Siris points to steady insider selling by REIT executives as a sign of the sector's overvaluation.

REITs can pass along their profits to investors free of federal corporate income taxes. Since 2000, their shares, on average, have more than doubled, while prices of single-family homes nationally are up by more than 50%-with some hot markets in California, Florida and the Northeast gaining 100%. The recent REIT weakness may not bode well for America's inflated home market because the key factors that affect REITs— interest rates and the economy— also influence home prices.

It's notable that REIT shares bottomed just as the technology bubble was about to burst in March 2000. That was a time when many investors decided that commercial property was being rendered obsolete by the Internet. The thinking was that Americans were going to do their shopping at the likes of Amazon.com, eToys and Webvan (an Internet grocer) while doing their banking online.

The opposite is true now. Institutional investors are clamoring to buy virtually every kind of commercial real estate, not just in the U.S. but around the world. "There's a global rush to buy real estate," Litt says. "It's driven by a desire to own hard assets, diversify and buy into a group that has been working."

The yield demanded by institutional buyers on U.S. commercial property has fallen to the 4%-6% range from 9% as recently as 2002. These yields, called capitalization rates, are based on the annual income generated by a property, divided by its purchase price. Litt points out that cap rates outside the U.S. now are comparable to those domestically, reflecting the growing efficiency of worldwide real-estate markets and the tens of billions of dollars looking for opportunities.

[Normxxx Here: Of course, that cuts both ways! ]

Cap rates are distinct from dividend yields. Dividends on REITs are a result of the income thrown off by the underlying properties and the mix of financing— common stock and debt— used to finance the properties.

ONE CAVEAT: REIT DIVIDENDS didn't benefit from the cut in the federal tax rate on dividends two years ago. Thus, they're disadvantaged relative to payouts on common stocks. The after-tax dividend yield on a REIT yielding 4.5% is around 3.2% for an investor in a high tax bracket. An investor could buy common shares of non-REITs yielding 4% and get an after-tax yield of 3.4%— beating the after-tax REIT yield.

A month ago, Litt did a computer screen and found that 88 companies in the S&P 500, S&P MidCap 400 and S&P 600 Small-Cap indexes had higher after-tax yields than the average REIT, up from just 27 in May 2003. The table, High-Yield Alternatives, lists some high-yielding alternatives to REITs, including the Baby Bells, Merck, Altria, Citigroup, Bank of America and Sara Lee.

What's the REIT bull case? Mike Kirby, the director of research at Green Street Advisors in Newport Beach, Calif., says that, if the U.S. is in a sustained period of low interest rates, REITs are apt to perform well. "The valuation question is tied up with the bigger-picture question of whether we're in a low-return environment for a long time. If that's the case, the 4.5% dividend yield on REITs doesn't strike me as too bad," given expectations that REITs' profits will rise 6% to 7% annually.

But Kirby and others acknowledge that REITs are likely to perform badly if the 10-year Treasury is heading toward a 6% yield.

REIT executives dismiss the bubble talk, pointing to the increasing demand among institutional investors

[Normxxx Here: Read: Hedge Funds! ]

for "alternative assets," as well as the underinvestment[!?!] in real estate by pension funds and endowments relative to their equity holdings. The U.S. commercial property sector is pegged at about $5 trillion, about half the size of the S&P 500 index.

REIT enthusiasts say that commercial real estate has undergone a revaluation that's unlikely to reverse,

[Normxxx Here: Wasn't that what they were saying in the late '80s when we sucked in all those Japanese investors? ]

driven in part by the increased cost of new buildings, which reflects higher costs for land, steel, copper, cement and other materials. The cost of putting up a new office building in Manhattan can run a stiff $650 a square foot— if a builder can find a lot to put it on.

IN DISCUSSING the real-estate bull market in his annual shareholder letter, Vornado's Roth wrote: "It may be caused by low interest rates. It may be caused by excess liquidity in the worldwide system. It may be caused by the flight to hard assets. It may be technical— worldwide institutions are under-allocated in this asset class; or it may even be for who knows what. And, it is a bull market in the face of flattish rents. Some think it is a bubble. I do not....Over the past several years, real estate has been repriced. I believe this is a long cycle move. Get used to it; give or take 10%, these prices are here to stay, for some time."

Buyers have been paying record prices
for all types of real estate, including the
Trump Place (top) and Aston (bottom)
apartment buildings in Manhattan.

In part, demand for REIT shares is coming from institutional investors redeploying money returned to them by firms that invest privately in real estate. Many funds are taking advantage of the bull market to monetize their holdings— and reap sizable fees. This creates reinvestment demand among investors, which is being channeled into the REIT market.

REITs tend to be valued based on measures other than earnings. In fact, their followers tend to ignore reported earnings, which are based on generally accepted accounting principles.

Why? GAAP profits require a noncash charge for depreciation expense, which reduces reported earnings. REIT investors deem depreciation to be a phantom charge, like the depreciation of a cable TV facility, because the value of the underlying property probably isn't really falling.

[Normxxx Here: But buildings do fall down or become unrentable after about 50 years or so. ]

The preferred profit measure is funds from operations, essentially reported earnings with depreciation and certain other costs added back in.

The problem is that, based on FFO, REIT stocks are at record valuations. The group trades for 15 times projected 2005 funds from operations, versus an average multiple of 11 during the past dozen years, according to Morgan Stanley. The REIT FFO multiple is almost as high as the S&P 500's price-earnings multiple of 17, based on projected 2005 operating profits. That's a rarity; historically, the FFO multiple has been much lower than the S&P's P/E. The forward 12-month REIT FFO and S&P 500 P/E are about the same.

FFO, however, overstates true REIT profits and cash flow. A better measure, according to Kirby and other analysts, is adjusted funds from operations, which takes FFO and strips out ongoing and necessary expenditures that realty trusts typically capitalize. For apartment REITs, it's the cost of new roofs, carpets, drapes and appliances. For office REITs, it's the cost of improvements to space rented to tenants on long-term leases, as well as commissions paid to brokers.

While the gap varies by REIT, the difference between FFO and AFFO is often 25%. "The capital expenditures you deduct are really akin to the recurring cost of running the business," Kirby says. "To not factor them in is to miss a lot of information." Office REITs tend to have a big gap between FFO and AFFO while storage REITs, like Public Storage, usually have a small difference.

Measured by AFFO, REIT valuations looks particularly stretched because the typical company trades at about 20 times estimated 2005 AFFO, considerably above the S&P 500's P/E ratio. And REIT dividends average about 90% of AFFO, a high percentage. In contrast, the S&P 500's payout ratio is around 30%. This means the average company in the S&P has far more room to raise dividends than the typical REIT.

Equity Residential, the leading apartment REIT, is likely to have $2.44 a share in funds from operations this year. That's less than the $2.63 it earned in 2001, yet its shares, at their recent price around 40, were 60% higher. And its annual dividend of $1.73 will barely be covered by the $1.86 in AFFO it's likely to generate in 2005.

Equity Office Properties, a leading office REIT, has risen 20% this year, to 35. Its projected 2005 FFO of $2.52 a share (excluding losses on property sales) is less than what it earned in 2000. Boston Properties, a favorite among REIT investors because of its exposure to two of the hottest office markets, Manhattan and Washington, D.C., has risen 18% this year, to a recent 76. It trades for a lofty 18 times estimated 2005 FFO, 25 times projected 2005 AFFO and yields just 3.6%.

REIT enthusiasts' counter that, while valuations may be stretched, based on FFO, AFFO or cash flow, they're still reasonable based on private-market values. The reasoning is that if Boston Properties liquidated its portfolio, it would realize more than its current stock price after paying off debt.

AGGRESSIVE INSTITUTIONAL BUYERS increasingly are outbidding REITs when properties come up for sale. The non-REIT buyers are willing to use more leverage— as much as 90% debt financing— while REITs generally employ a roughly 50/50 mix of debt and equity. A similar situation exists in the home market, in which buyers making down payments of as little as 5% are helping to fuel demand.

<img Align="Right" hspace="10" vspace="5" src="http://online.barrons.com/public/resourc...">The cautious stance of REITs regarding acquisitions is another sign of a frothy market. Boston Properties has been a net seller of office buildings, while Vornado has shifted gears and has sought real-estate plays in the stock market. Vornado is part of a group that purchased Toys "R" Us for $7 billion, and it took a sizable position in Sears Roebuck last year, prior to Kmart's deal to merge with Sears, because of Sears' valuable real estate. It now owns about $400 million of Sears Holding (SHLD) stock. Vornado issued nine million shares on Thursday at 86.75, leading bears to conclude that it wants to raise as much as it can before REIT stocks decline. The Vornado deal wasn't a winner because the stock fell $1.50 Friday to 85.50.

"Given our underwriting standards and our return requirements, we are seeing a paucity of acquisition opportunities," said Ed Linde, the chief executive of Boston Properties, on the company's second-quarter earnings conference call in late July. Boston Properties recently announced a $2.50-a-share special dividend, reflecting proceeds from property sales.

LINDE CITED ANOTHER SIGN of an overheated market. While buyers of office buildings historically have favored properties with high occupancy levels, many potential purchasers now prefer buildings with sizable vacancies because they assume they can push through big rent increases. The reality is that while office rents in key markets have firmed, many office REITs still are getting lower rents on new leases than on expiring leases signed in the 1999-2001 period.

Manhattan remains a center of the real-estate boom. Apartments fetch $1,000 a square foot or more. Thus, a modest-sized two-bedroom apartment can cost $1 million. Prime office space on Park Avenue is going for as much as $100 a square foot— two times the rates for similar space in Boston and San Francisco.

Equity Residential, the country's largest apartment REIT, recently agreed to pay $816 million for three apartment buildings in Trump Place in Manhattan. That worked out to nearly $600,000 per apartment and a capitalization rate of only 4.5%. Bulls cited the opportunity for Equity Residential to turn the apartments into condos and sell them for a sizable gain— although the buildings' seller presumably was aware of that possibility.

APARTMENT REITS ARE BACK in favor, partly because investors are figuring that they may engage in wholesale condo conversions to capitalize on the roaring condo market. Watch out if the condo market cools.

<img Align="Left" hspace="10" vspace="5" src="http://online.barrons.com/public/resourc...">Elsewhere in Manhattan, another rental apartment building, the Aston, on the now-fashionable strip of Sixth Avenue in the mid-20s, recently was sold for $195 million to Archstone-Smith, another real-estate investment trust, according to the New York Post. That works out to $800,000 per unit and $1,000 a square foot. The Aston sale could be the richest ever for an apartment building on a per-unit basis. The Aston and Trump purchases reflect an effort by apartment REITs to upgrade their portfolios by buying properties in hot markets and selling them in weaker markets in the South and West, where rents are soft and barriers to new construction are low. The benefits to investors from this strategy are unclear because REITs are accepting earnings dilution by buying high and selling low.

Mall REITs have enjoyed some of the strongest profit gains because of a robust consumer economy. Simon Property, the leading mall REIT, recently reported a 16% gain in second-quarter FFO. Its FFO is expected to rise 11% this year and 6% in 2006. Simon, however, isn't cheap at 80, trading for 16 times projected 2005 FFO and 22 times AFFO.

The mall REITs face a challenge because of growth in off-mall retailers like Target and Wal-Mart Stores and the consolidation among department stores, highlighted by the coming merger of Federated Department Stores and May Department Stores, which will result in the closing of anchor stores in many malls. Guerrilla Capital's Siris notes that America "remains overstored," yet investors are more bullish than ever about mall and strip-center REITs. Siris fears that with anchor stores closing, "a lot of the second-class malls will get hurt badly."

The formerly dowdy storage REITs, led by Public Storage, have capitalized on Americans' penchant for accumulating more than they can fit into their homes. The storage industry has done particularly well in the South and West, where many homes lack basements.

Public Storage last week offered to acquire a smaller storage REIT, Shurgard Storage (SHU), for $2.5 billion, or about $53 a share— 14% above Shurgard's share price prior to the offer. Shurgard dismissed the offer as inadequate, even though it amounted to 26 times that company's projected 2005 FFO of $2.05 a share. Shurgard was trading late last week at 52.

It's tough to say when real-estate investment trusts— or any overheated industry group— may cool down. Yet the feeding frenzy surrounding the group, along with the low yields and high valuations, has left many disciplined buyers on the sidelines. And it's turned some big institutions into sellers.

The California Public Employees Retirement System, which has one of the largest real-estate portfolios among public pension funds, has sold $7 billion of its $21 billion core portfolio since December. Calpers sold most of its office properties. "The prices that people were willing to pay were higher than what we felt the properties were worth," observes Michael McCook, Calpers' senior investment officer for real estate. He says the fund had bought the properties at cap rates, or yields, in the 7% to 9% range and sold them in the 4% to 6% area.

Bulls talk of a new era of permanently elevated property prices. Tech-stock boosters said much the same in 1999 and 2000, before that group collapsed. Given their huge run-up, REIT shares could be at least 10% lower within 12 months. So now might be a good time for investors to move away from them. In real-estate investing, location, location, location isn't always the most important thing. Often, timing is.

[Normxxx Here: Isn't it some kind of warning when you make the cover of Barron's? ]

The contents of this letter/report does not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

-- posted by Normxxx