With EOP’s deal finally being done by Blackstone, it’s time to state the obvious - I have been mostly wrong on the REITs. Right now HEDGEfolios has about 25 of the 130 REITs with UP signals and clearly, that has not been enough. I still don’t see them as good entry points for both fundamental and technical reasons so it’s likely that I won’t change anything at this point.

Blackstone’s initial offer had implicit cap rates at about 6% and with the Vornado bidding war, the final figure is closer to 4%. While 6% was consistent with some other deals, the premium on “the largest LBO in history” seems over the top. Regardless, the bigger factor for me to consider is the new metrics that are being applied across the REIT universe. As is usually the case, the entire sector is getting bid up based upon EOP’s deal so I am spending a lot of time trying to figure out whether my analysis still holds or whether I should cave in and jump on the bandwagon.

One of the things that keeps coming up to justify higher REIT prices and private equity premiums is the replacement cost, but unless you are an expert on real estate construction, it’s tough to make those kind of assessments. Cohen & Steers, EOP’s largest shareholder, had insisted that replacement cost was equivalent to $60 per share and they did a good job getting close to that figure. I have no idea how to estimate replacement costs on other publicly traded real estate and prefer analyzing Net Asset Values estimated by research firms that specialize in this area. One source is Green Street Advisors who said REITs currently trade at a 7% premium to their underlying property values. That’s not historically high given that the premium was 33% in 1997 before the slide in REITs (1998 to late-1999) when they leveled off at a 20% discount to NAV.

The primary reason I don’t like this sector at these prices has nothing to do with steel, brick and mortar - it has to do with the cash flow valuations. Specifically, the multiples being used today are not consistent with historical norms for this sector. According to Invesco’s excellent report, REITs were trading at 10.6 times Funds From Operations (FFO) in 1994 and they are now almost twice as expensive with a Price to FFO multiple of 18.5 (12/2006.) While the S&P PE has declined since 2000, the P/FFO ratio has risen dramatically and is significantly higher than its 10-year average of 12. Having REITs trading at a premium to market multiples seems unlikely, but that is what we have now. In fact, if you do a derivative of the PEG ratio for REITs, you’ll see a “P/FFO to Growth Ratio” of 3.08.

If you don’t trust those measures, just look at REIT dividend yields compared to the 10-year Treasury. Since 1994, REIT yields on average have traded at a 120-basis-point premium to 10-year U.S. Treasury bond yields and over the past 10 years, it’s 142 basis points. Currently, the average REIT yields 3.78% according to NAREIT, about 100 basis points lower than the Ten-year Treasury note of 4.75% (they have never been this low on a relative basis). The last time REITs had payouts less than Treasuries (1998) they fell 17%. Lastly, over the past 15 years during instances of flat or inverted yield curves, REITs have underperformed the S&P 500 by about 15 percent. No matter how you look at the relationship between Treasury and REIT yields, it’s not good.

Historically, REIT yields have exceeded the S&P 500 yield by several hundred percent with some periods having an 800 bps spread. The current average REIT yield of 3.78% is still more than twice as high as the average stock in the Standard & Poor’s 500 with yields of just 1.8%. However, the current REIT yield is half the 8% it paid in 2000 and well below the 10-year average of 6.26%. With typical FFO and dividend growth rates of about 6%, it’s tough to see the yield improving substantially unless the REIT share prices decline. I am not saying that I expect prices to drop precipitously and immediately, but the odds that the market will be able to ignore the factors I mentioned in this post are very poor. So if you insist on speculating on the REITs, make sure you consider the individual stock and its:

• Premium or Discount to NAV,
• Price to FFO multiple,
• Dividend Yield vs. S&P 500 Yield, and
• Dividend Yield vs. 10-year Treasury.