by Elaine E. Derso
Having been becalmed during run-up of the S&P 500 and, more recently, the NASDAQ 100, REIT stock prices may be on their way, at last, to approximating net asset values. Most property sectors have posted double-digit returns since mid- December. Even so, REIT stocks are still generally trading below net asset value and have room to appreciate further on a valuation basis.
Industry Fundamentals Are Solid
The fundamentals to support a sustained price improvement are in place. In the past, unchecked capital flows into real estate have typically killed the goose that laid the golden egg by funding speculative development. But the rapid growth of the REIT industry since 1992 has introduced a level of rationalism and discipline into the real estate capital markets that did not previously exist. As a result, most property sectors are in or are close to being in balance between supply and demand.
Debt levels are manageable. Coverage ratios began to decline in early 1998, as REITs took on additional debt in the face of closed equity markets, but they have been improving since the second quarter of 1999 and are likely to continue to improve as earnings continue to grow. Moreover, the shape of the yield curve has encouraged more matching of assets and liabilities.
Funds from operations (FFO) appear likely to grow at a respectable rate at least through 2001, assuming a strong economy. The rapid growth in FFO that came from acquisitions, more extensive development, and the initial stages of management rationalization has passed and been replaced by a slower, more sustainable pace.
But Valuation Remains Low
Price/FFO per share multiples are significantly below those of the broader markets, typically in the 8x's to 9x's range. Even if they rise to a relatively modest 13x's to 15x's range, there is considerable upside potential for the stock prices. Moreover, REIT share prices still tend to be below net asset value. No matter how one measures value, REIT stocks qualify as value stocks right now.
Volatility in the technology sector seems likely to encourage investment flows into value stocks that hold some potential for price increases. REIT stocks fit this description, while also offering the protection of significant dividends. Indeed, the dividends alone may be enough of an attraction for income-oriented investors.
Recently there have been signs of a break between the valuation of large and small capitalization REITs, with the former trading at higher multiples than the latter. As institutional investors move into REIT stocks, this break is likely to persist and may even grow. The simple mechanics of trading large numbers of shares require liquidity, so institutional money is biased toward the larger REITs, all other selection criteria being equal.
Bottom Line Is Positive
Renewed attention in REITs is coming at an interesting time for the industry. The enactment of the REIT Modernization Act increases the importance of assessing corporate business strategy at a time in the real estate cycle when earnings increases are settling down. The REIT industry is maturing, and investors appear ready to recognize this in the year 2000.
Elaine E. Derso is a principal of Realty Resources.
