REITs have enjoyed a blissful five years of rising share prices that insulated them from the rapid fluctuations common to other securities. During that stretch, REITs outperformed every major index with the exception of the NASDAQ's 50% return in 2003 as it recovered from major losses the previous year.

In both 2003 and 2004, REIT returns topped 30%, thanks to share prices that escalated with mushrooming demand for REIT stocks (see table on page 26).

This year, however, REIT shares are showing signs of vulnerability. While they continue to outperform broad indices such as the S&P 500, they have begun to fluctuate, suffering a 9% loss in August when investors became jittery over a drop in bond prices.

REITs historically have exhibited far less volatility than other major indices, but the 4.68% annualized volatility of REIT returns in the past year exceeds the NASDAQ's 4.27% and the S&P 500's 2.26% for the same period, according to the National Association of Real Estate Investment Trusts.

In part, this newfound shakiness reflects divergent views of REIT values. REIT shares are now stuck in a tug of war between those who fear a buying frenzy has driven prices too high, and others who see plenty of growth potential ahead as commercial real estate in general recovers from a slump.

One camp cites rising interest rates, a slowing U.S. economy, and record valuations of commercial real estate (despite pressure such as energy prices on operating results) as reasons to back away from REITs now. Others say those same commercial real estate valuations, translated into the net asset value of a REIT's holdings, justify the high prices on REIT stocks, especially after adding in a premium for the greater liquidity and shared-risk benefits REIT shares enjoy over direct ownership of real estate.

“We're getting mixed signals. Valuation today is very much in the eye of the beholder,” says Kelly Rush, director of portfolio management for Principal Global Investors. Principal Global is the asset management arm of Principal Financial Group and manages more than $155 billion in assets, primarily for institutional clients.

Investors escalate prices

Ironically, it wasn't revenues or dividends that brought REIT share prices to their current heights so much as it was a flood of capital into REIT mutual funds and other instruments by individuals and institutions seeking a level of returns that the overall equity markets still do not produce. A record $6.9 billion entered the sector in 2004 — a 45% increase from the previous record of $4.75 billion set in 2003 — according to Arcata, Calif.-based AMG Data Services, which tracks mutual fund money flow and holdings data.

Most analysts today suggest investors buy REIT stocks based on company-by-company evaluations rather than load up on one or more sectors, but the money keeps pouring in and the demand for shares continues to drive up prices.

REIT shares traded at multiples eight to 10 times funds from operations (FFO) per share from the late 1990s until mid-2000. That multiple has soared to an average of 16.8 times FFO for the 12 months ended Aug. 30 this year, according to SNL Financial (see chart below). That's close to the S&P 500's average price to earnings multiple of 17.

By contrast, REIT shares appear reasonably priced relative to net asset value, which is the total value of a REIT's real estate holdings, minus debt. REIT shares were trading at an average price of 111.3% of net asset value per share as of Sept. 16, according to Bear Stearns & Co.

In a worst-case scenario, a sharp rise in interest rates could lower real estate values and REIT share prices. A correction from the current multiple of 17 times FFO to 10 times FFO, for example, would mean losses in excess of 40% for investors. When REITs commonly traded at multiples of nine and 10 at the start of the decade, however, the benchmark 10-year Treasury yield was 6.7%. Economists don't expect interest rates to return to that level in the foreseeable future. The 10-year rate was just over 4% on Sept. 1.

Whatever the future holds, the smooth sailing is over. To understand why experts recommend weighting some investments and underweighting others requires an understanding of how those analysts and fund managers view current conditions, risks, and prospects for change.

Expect volatility to increase

Whether you believe that commercial real estate stocks are overvalued, fully valued or even undervalued, it is clear that they have posted a remarkable record that is unlikely to be sustained. And the performance gap versus other equities is narrowing. In 1999, at the peak of the technology boom, REIT shares priced at 8.4 times FFO were a steal compared with S&P stocks trading at nearly 28.8 times earnings, according to data provided by Bear Stearns.

In 2003, the S&P multiple had dropped to 20.1 and REITs were at 14.2 times FFO. By the end of this year, however, the difference between those numbers will nearly disappear with REITs trading at 16.2 times FFO and the S&P at 17.1 times earnings, Bear Stearns estimates.

For those seeking yield, REIT dividends have lost some of their luster as well. In August 2001, REIT dividends averaged 8.05% or nearly double the 4.53% yield on the 10-year Treasury. For the 12 months that ended July 29, 2005 — just before the REIT sell-off — REIT yields were down to 4.30%, nearly equal to the 4.28% on the 10-year bond, according to SNL Financial.

REIT sell-offs in August 2005, April 2004 and July 2002 gave investors a taste of market volatility that will occur with greater frequency now that REIT shares are on a more equal footing with competing investment options. “When you're fully valued in the capital markets and other assets rise in value, you're going to fall in value unless you keep pace,” says Doug Poutasse, chief investment strategist at AEW Capital Markets.

That became painfully clear in the REIT sell-off that began Aug. 4, when a positive job growth report caused a spike in the 10-year U.S. Treasury bond yield, which came to within 19 basis points of the average REIT dividend. The long-term average spread between the two yields is 117 basis points, according to Merrill Lynch. The high Treasury yield sent many investors scrambling to sell REIT shares and buy bonds. Augmented by bearish news coverage of high REIT values, the slide brought the Morgan Stanley REIT Index down 8.9% in three days of trading. (That REIT index was renamed the MSCI REIT Index effective Aug. 31, 2005.)

Concerns over rapidly rising REIT values and the specter of rising interest rates contributed to the two previous sell-offs as well. A six-week episode in April 2004 brought the market down 19%, and another occurred in March the previous year when investors feared a rise in interest rates would hurt REIT performance. “If this was a wake-up call, then it was the third one,” Poutasse says of the correction in August.

The activities of hedge funds and other short-term investors who have entered the REIT market since the technology crash tend to exacerbate the unpredictability that has emerged in REIT trading during the past two years, says Steve Buller, portfolio manager for the $5.85 billion Fidelity Real Estate Investment Portfolio.

“Hedge funds need volatility, and where they go, they create more volatility. I don't think volatility is going to subside in the REIT market until volatility returns in the broader equity markets,” Buller says.

Buller says investors who use REITS as a way to hold real estate long term aren't overly concerned about share price volatility. Over time, REITs will reflect the more predictable nature of the underlying real estate, he says.

A fundamental disconnect?

Perhaps the greater worry for investors isn't that REIT values will fluctuate relative to other investments, but rather that fundamentals can no longer support these share prices. As with other hot investments, REITs could turn cold if investors begin to doubt the ability of the companies to produce returns that can justify lofty multiples.

The doubling of REIT share prices relative to earnings since the late '90s is, in itself, alarming to some industry watchers. “That kind of expansion without the accompanying earnings growth is causing concern in the investment world,” says Kevin Lindemann, real estate director at SNL Financial.

What's troubling about REIT earnings growth? Companies with high earnings growth tend to trade at relatively high valuation multiples. REITs have the multiple, but not the growth: While earnings for the S&P 500 companies increased by 17.7% in 2004, REITs recorded just a 2.7% rise in net earnings, estimates Bear Stearns.

Fund flows have been a bigger determinant for REIT prices than earnings. But the flow has slowed in 2005, taking another pin out from under REIT prices. Through the first week of September, $3.25 billion flowed into REITs, according to AMG. The August sell-off even turned flows negative during the week of August 10 as $322.3 million poured out of REIT mutual funds. The bleeding slowed to a negative outflow of $57 million for the final week of August, according to Bear Stearns.

In line with net-asset values

Still, the tug-of-war in the market continues. Many analysts aren't convinced that REIT shares are yet overpriced. “The stocks are richly valued, but not necessarily fully valued by historic standards,” says Ross Smotrich, managing director at Bear Stearns.

Indeed, relative to net asset values, REIT shares are selling at or below the historical average. Shares were selling at 105% of net asset value at the start of 2005 but fell to 99% immediately after the sell-off in August, according to Merrill Lynch. In the previous market sell-off of April 2004, share prices began at 116% of net asset value and fell to 102% by the end of the correction. Merrill Lynch calculates the sector's long-term average at 103% of net asset value (see chart on page 28).

While the days of 30% annual returns may be in the past, Smotrich of Bear Stearns expects REIT returns in the mid-teens in 2006. That will reflect a dividend yield between 4% and 5% and an additional 8% to 9% growth from earnings. Those projections are based on several factors that include recovering real estate fundamentals in markets across the nation, continued interest in real estate by investors and a lack of sufficient alternative investments outside real estate.

The discrepancy between REIT values measured by FFO and those measured in relation to net asset value isn't a concern to some industry insiders. REIT net asset values have increased along with the rest of the real estate market, in which low interest rates have fueled a rise in property values, says Fidelity's Buller. Prices are high in relation to FFO, but those funds are understandably low as the market emerges from a slump.

Market fundamentals, however, are improving across virtually all property types. The nation absorbed 8.3 million sq. ft. of office space in the second quarter of 2005 to mark the fifth consecutive quarter of positive absorption in both downtown and suburban markets. The national office vacancy rate of 14.8% dipped from 16.6% a year earlier, reports CB Richard Ellis. Industrial vacancy declined for seven consecutive quarters to register 10.2% in the second quarter.

REIT earnings are, in fact, accelerating to reflect rising occupancy and rental rates: In 2003, FFO fell by an average of 2.4% per share. In 2004, average FFO per share advanced 2.7% and will likely close this year with a 7.2% gain, according to Bear Stearns. By the end of 2006, REITs are projected to increase funds from operations by 9.6% per share.

If REITs were undervalued at the start of the decade, then the industry's high returns of 36.74% and 31.49% in 2003 and 2004, respectively, were due in part to prices catching up with values. Now that REITs may be fully valued even in relation to their underlying real estate, analysts expect future returns to more closely reflect earnings growth.

That means investors should expect more modest returns from their REIT holdings than they have in the past few years, says Keith Pauley, portfolio manager at LaSalle Investment Management, which handles investments for institutional clients. “But we're not in the camp suggesting we're in a bubble, or that we're going to see a sharp correction in prices.”

Insiders sense a top

So, what is the smart money doing now? One indicator that market strategists like to check is insider sales. By this measure, it would seem, the top executives in the REIT industry are saying that prices have reached their peak. Among REIT managers and directors, sellers of company stock outnumbered buyers by 173 to one in the second quarter this year for a total of $296 million of insider trading, outpacing the previous record of $275 million set in the fourth quarter of 2003, according to a report by Lehman Brothers analyst David Harris.

The report attributes the selling spree to soaring stock prices, and prompted widespread speculation among industry watchers that insiders might sense an overpriced market, but Harris is quick to point out that insider selling has been on the rise for a couple of years. “We shouldn't put too much emphasis on insider selling as a sign that stocks are overpriced,” he says.

The sales, says SNL's Lindemann, merely reflect what everybody knows — that REIT shares have established highs in recent years. But, he says, insider selling does not indicate that the shares are overvalued. Insider sales have spiked on highs in previous years, too, he says. The insiders, he says, “are as surprised as anyone that REITs have become as popular as they have become.”

Interest rates are the wildcard

A more difficult question facing REITs and investors is whether all real estate, both publicly and privately owned, is overvalued relative to other financial asset classes. “If this low interest-rate environment sticks, then this re-pricing of commercial real estate will have been justified,” says Rush of Global Principal Investors. “If the re-pricing doesn't stick, then probably the multiples are too high and we will see some re-pricing of REIT shares.”

A sharp increase in interest rates could force buyers to seek higher cap rates on property acquisitions, which would reduce the overall amount buyers are able to pay for real estate and thereby signal a reduction in property values. But few experts expect to see long-term interest rates climb quickly. Global market forces such as new sources of labor will help to maintain the affordability of goods and counter inflationary pressures, and without significant inflation, interest rate increases should be gradual.

With improving fundamentals, REITs may be able to increase earnings and justify their higher share prices. Stronger earnings would also make those companies better able to handle a gradual rise in interest rates without crimping dividends or total returns.

Even if the market avoids a large correction, however, investors should brace themselves for the occasional jolt in trading that comes with a fully valued securities market, such as the recent sell-off. Poutasse of AEW Capital says the occasional spike or slide is now part of the REIT landscape. “These are reminders that you do have stock market volatility in this sector and you need to be ready for that, but they also bring very interesting buying opportunities.”

Matt Hudgins is an Austin, Texas-based writer.

REIT RETURNS VS. INVESTMENT ALTERNATIVES

Domestic price-index returns are listed in annual percentage changes.
2005 YTD* 2004 2003 2002
MSCI REIT INDEX** 11.68% 31.49% 36.74% 3.64%
S&P 500 2.02% 8.99% 26.38% -23.37%
NASDAQ -0.16% 8.59% 50.01% -31.53%
Dow Jones Industrial Average -1.39% 3.15% 25.32% -16.76%
*As of Sept. 7, 2005
** Formerly the Morgan Stanley REIT Index, the MSCI REIT Index measures the percentage change in total returns, defined as the aggregate value realized by a common shareholder during the year, including price increases and dividends paid. The dividends are reinvested into additional shares of common stock.
Source: SNL Financial