Mirror, Mirror, on the Wall

Published in the March/April 2012 issue of REIT magazine

Who’s the fairest of them all? Unfortunately, the answer frequently depends on whether the judges prefer blue rather than red dresses this year. Shifting investor preferences are nearly impossible to predict, yet investment popularity (or lack thereof) will heavily impact prices and valuations, sometimes for several years. There is little that even the most astute corporate executive can do to rectify belonging to an out-of-favor group, and the careers of smart portfolio managers have been cut short by the vagaries of these beauty pageants. REITs were doing well in the late 1990s, but finding an investor who wanted to own REIT shares at that time was as difficult as finding a Rhodes Scholar amidst a Hell’s Angels biker gang.

"Although no trend lasts forever, the popularity of commercial real estate and REIT shares is, today, quite justified."

Making the problem even more nettlesome, investment popularity (and unpopularity) is usually grounded in the realities of expected growth rates, interest rates and macroeconomic risk. Markets are not always efficient, but they usually survey the landscape pretty well. Today, equities are not terribly popular with risk-shy investors and, accordingly, PE multiples are very modest – especially in the context of very low interest rates. We can buy the stocks of excellent companies such as Deere, Exxon and Microsoft for just 10x earnings. But perhaps these low multiples and high-risk premiums simply reflect peak profit margins, reluctant consumers, weakening growth rates, political stalemate and the risk of contagion from the troubled Eurozone.

On the other hand, high levels of risk aversion have helped the prices of good quality commercial real estate in well-established markets to rebound substantially, in some cases approaching pre-recession highs. The investment popularity of commercial real estate today is also seen in the superior performance of most equity REIT stocks, which now trade at very generous multiples of FFO and AFFO. Indeed, if we compare the “earnings yields” at which various stocks trade, it would be easy to conclude that listed REIT stocks – despite their unjustified and frustrating volatility – are significantly more popular today than their non-REIT cousins.

So a key portfolio management issue for today’s investors is whether REIT shares will continue to trade at lower risk premiums than other common stocks. Although no trend lasts forever, the popularity of commercial real estate and REIT shares is, today, quite justified. It reflects several known facts, including the resiliency of most space markets in the face of the Great Recession and a “new normal” economic recovery, the intelligent deleveraging and smart capital allocation decisions of REIT management teams in recent years and the relatively low-risk profile of commercial property owners.

Furthermore, yield-oriented asset classes tend to be better appreciated, and valued more dearly, when earnings growth and profit margin sustainability in Corporate America are being questioned. Compare our markets in the waning years of the 20th century, when risk was the national pastime and double-digit investment returns were viewed as investors’ natural right.

Valuations, PE multiples and risk premiums reflect both perceived growth prospects and investment risk. I suspect that, to the extent today’s very substantial macroeconomic headwinds continue to blow across the investment world and worry investors of all stripes, the significant premiums afforded to commercial real estate and REIT shares will remain in place. This will not always be so. Eventually, real estate cap rates will rise, performance-seeking capital will move elsewhere and REIT stocks will trade at earnings multiples roughly in line with those of other stocks. We have seen this movie before. But, for now, the judges are winking at us, and will likely favor us for another couple of years. My suggestion to REIT executives is this: Remain humble, and don’t confuse genius with a bull market.

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Ralph Block is the author of “Investing in REITs” and “The Essential REIT” blog.

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