Reit Valuation

A conversation with business associates, conducted yesterday about real estate investments. We discussed the investment drive vs securities investment (purchase of land or buying stocks), evaluation, risk and the concept of fair value.

This conversation led an interesting question that I thought I would address here.

The question for which there are many competing answers, was: how do you value an investment property (in particular), or any other investment, anyway?

Firstly, the value is always determined by the buyers because if a buyer does not see the value, no transaction takes place. As a buyer of a REIT, I could look in two ways: 1) I value the investment based on earnings yield (dividends), or 2) I value the investment based on the price I m 'wait for buyers to pay in the future (capital gains). Most investors want both, but tend toward one or the other, for example, an investor bias in favor of capital gains would be the dividend as a safety net, while the investor biased dividends for capital gains would be a bonus.

Historically, REIT investors have been looking for investors to dividends that the potential capital gains. REITs are not structured to function as a proxy for earnings in the underlying real - you're looking for a stream of rental income, no title to commercial property. Based on cost of capital, legal structure, and long-term holdings of REIT typical value comes when properties are improved and rents go up, not when the price of the underlying rises.

Given this historical bias, how the dividend yield of REITs compared to watching it is medium to long term? I analyzed 20 years of data and found that the current yield is 250 basis points below its long-term average. In terms of raw performance, the lowest point over the past 20 years.

In addition to the historically low yields, my research shows that in the past 20 years, REITs have provided a premium of 137 basis points over the rate to 10 year Treasury. This spread is the compensation investors expect to take the excess risk. The current situation, however, is revealing: there is actually a negative difference. This means that REIT investors are not compensated for excess risk. You may receive the same return on Treasury bills in no risk. This risk premium is also freer to its lowest level in 20 years.

In the current situation of performance, there are two opportunities to raise yields in proportion to their historical averages:

1) earnings, dividends and therefore, should increase, or

2) Prices must come down.

Given the cost of capital and legal structure, not to mention the current housing and financial markets, REITs do not have the ability to significantly grow their revenue. Since they are required by law to pay 90% of their net profits as dividends to investors, they do not have the pool of retained earnings to make acquisitions of other companies that do, so they must collect funds by borrowing (or bank loans or selling bonds). It is a risky proposition in a market environment today. So unless they can develop properties and raise rents, they are unlikely to be able to increase their income at a high rate.

Add to this the fact that the LBO premium, "which was built in the prices of REITs in the past fades away, as PE firms have become much more selective about their takeover targets because they have a pool of hardened considerably capital to work with. In the absence of PE companies tripping over themselves to take your private company, you as an investor must assess the REIT on its fundamentals, and this means that the dividends.

This leaves the REIT average buyer looking to buy at lower prices in.