C H A P T E R T H E Quest FOR INVESTMENT VALUE S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0 210 I N V E S T I N G I N R E I T S S uccess in REIT investing will be determined, at least over the short term, by the ability to buy REIT stocks at attrac - tive prices. In this chapter we’ll look at some yardsticks for determining the investment value of a REIT’s stock. Sure, we want to buy high quality, moderate risk, and above-average growth, but only at prices that make sense. T H E I N V E S T O R ’ S D I L E M M A : B U Y A N D H O L D V E R S U S T R A D I N G One school of thought is that the key to investment success is to purchase shares of stock in the largest, most solid companies, or to buy index or mutual funds, and to hold those stocks or funds indefinitely. The only time to sell, say the buy-and-hold advocates, is when you need capital. The other school of thought—a more hands-on approach—says that, with hard work and good judgment, an intelligent investor can beat the market or the broad-based averages—either by astute stock picking or by clever market timing. Some advocates of this approach, which rejects the theory that markets are “efficient,” point to investors like Warren Buffett and Peter Lynch as examples of what a talented stock picker can accomplish, while others in this group believe that certain signs—technical or even astrological— can indicate when either the entire market or specific stocks will rise and fall. Advice for the buy-and-hold crowd is simple: Assemble a port - folio of blue-chip REITs or buy a managed REIT mutual fund or an index fund. Then, if you’ve chosen solid stocks or performing funds, you can go off to Tahiti, collect the steadily rising dividends, and not worry about price fluctuations, beating the competition, or any other such irrelevancies. If history is any guide, such a strategy may be able to average 8–12 percent in total returns over a long time horizon. Advice for the active trader or the REIT investor who desires to perform better than the REIT market is somewhat more compli - cated. First, you must have a way to determine when a REIT stock is overpriced or underpriced, given its quality, risk, underlying asset values, and growth prospects. Second, you must have a way to deter - mine when REIT stocks as a group are cheap or expensive. Valua - 211 T H E Q U E S T F O R I N V E S T M E N T V A L U E S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0 tion of any stock is never easy, but there are guidelines and tools that can help determine approximate valuation. Before examining REIT valuation methods in detail, let’s take a closer look at the buy-and-hold strategy and the logistics of putting together a diversified portfolio of blue-chip REITs. T H E B U Y - A N D - H O L D S T R A T E G Y The buy-and-hold strategy has a number of advantages. Inves- tors don’t need to worry about fluctuations in rates of FFO growth, occu - pancy or rental rates, or even asset values. Also, since these investors are not active traders, commission costs and capital gains taxes are much lower. Furthermore, if the effi - cient-market theory is correct, it’s not possible to beat the mar - ket anyway. If not, an index-based, buy-and-hold REIT portfolio will slightly outperform a traded portfolio or an actively managed mutual fund. However, buy and hold has some disadvantages. If mutual funds are used—whether indexed or actively managed—investors will pay an annual management fee and other expenses and, in some cases, a marketing or sales charge. Mutual funds often involve extensive record-keeping, especially when dividends and capital gains are reinvested. And, on occasion, entire property sectors may underperform for a number of years; buying and holding forever may not generate the best returns. Investors who like the buy-and-hold approach to REIT investing but who don’t want to go with a REIT mutual or index fund (or, as we’ll review in Chapter 10, exchange-traded funds) should be careful to construct a portfolio consisting primarily of a broadly diversified group of blue-chip REITs. These REITs are likely to grow in value over time, notwithstanding occasionally difficult real estate markets, and to have managements that can be counted on to avoid serious blunders. They can be compared to blue-chip, non-REIT stocks such as Johnson & Johnson, Coca-Cola, General Electric, Intel, and Procter & Gamble. The blue-chip REIT of the type we discussed in the previous chapter isn’t always large in size; there are a number of excellent smaller REITs, not specifically mentioned in 212 I N V E S T I N G I N R E I T S S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0 this book, that qualify as blue chips. The investor may also want to include some “growth,” “value,” or “turnaround” REITs for addi - tional diversification. Of course, not all blue-chip REITs will deliver the expected returns, since individual companies are subject to management mis - takes, changing economic conditions, overbuilt markets, declining demand for space, and a slew of other potentially negative devel - opments. Furthermore, all stocks, including REITs, are subject to periodic bear markets, sometimes having little to do with how the company itself is performing. R E I T S T O C K V A L U A T I O N Active REIT investors will want to spend time analyzing and applying historical and current valuation methodologies to seek maxi - mum investment performance for their portfolios. Investors who are not content with the buy-and-hold strategy and who want to buy and sell REIT stocks more actively and take advan - tage of undervalued securities will need to know how to determine value. After all, it doesn’t make sense to overpay, even if you’re buy - ing blue-chip REITs. How can we determine what a REIT is worth relative to other REITs? And how can we decide whether REITs as a group are cheap or expensive? Professional REIT investors and analysts all have their own approach; there is no consensus as to which one works best. Thus, although there is no Holy Grail of REIT valuation, there are commonly used methods and formulas that can provide crucial insight into a REIT’s relative investment strengths and weaknesses, bands of reasonable values for a REIT’s stock price based on his - torical precedent, and even the fairness of pricing within the entire REIT industry. RE A L EST A TE AS S ET VA L UES Until fairly recently, investment analysts have thought it important to look at a company’s “book value,” which is simply the net carrying value of a company’s assets (after subtracting all its obligations and liabilities), as listed and recorded on the balance sheet. Whatever 213 T H E Q U E S T F O R I N V E S T M E N T V A L U E S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0 the merits of such an approach in prior years, investors today place more emphasis on a company’s “going concern” value and growth prospects than upon tangible assets such as plant, equipment, and inventory. Furthermore, “intellectual capital” and “franchise value” are also deemed more important than the value of physical assets. Indeed, few stocks sell today at prices even close to book value. Book value has always been a poor way to value real estate com - panies because offices, apartments, and other structures do not necessarily depreciate at a fixed rate each year, while land is carried at cost but tends to increase in value over time. Although some analysts and investors like to examine “private- market” or liquidation values rather than book values, the majority today focus on a company’s earning power rather than its breakup value. Nevertheless, while most of today’s REITs are operating companies that focus on increasing FFO and dividends and will rarely be liquidated, they do own real estate with valuations that can be assessed and approximated through careful analysis. Fur - thermore, these assets are much easier to sell than, say, the fixed assets of a manufacturing company, a distribution network, or a brand name, and thus the market values of their assets are much easier to determine. REITs are much more conducive than other companies to being valued on a net-asset-value (NAV) basis, and many experienced REIT investors and analysts consider a REIT’s NAV to be very important in the valuation process, either alone or in conjunction with other valuation models. One of the leading advocates of using NAV to help evaluate the true worth of a REIT organization is Green Street Advisors, an independent REIT research firm that has a well-deserved, excel - lent reputation in the REIT industry for its in-depth analysis of the larger REITs. Green Street’s primary approach is first to determine a REIT’s NAV. This is done by reviewing various segments of the REIT’s properties, determining and applying an appropriate cap rate to groups of owned properties, and then subtracting its obliga - tions as well as making other adjustments; undeveloped land and developments-in-process are valued separately, then added in. The 214 I N V E S T I N G I N R E I T S S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0 current value of debt is also taken into account. Recognizing that REITs vary widely in quality, structure, and external growth capa - bilities, it then adjusts the REIT’s valuation upward or downward to account for such factors as franchise value, sector and geographical focus, insider stock ownership, balance sheet strength, overhead expenses, share liquidity, and possible conflicts of interest between the REIT and its management or major shareholders. The net result, under Green Street’s methodology, is the price at which the REIT’s shares should trade when fairly valued. The firm uses a relative valuation approach, weighing one REIT’s attrac - tiveness against another’s. It does no t attempt to decide when a particular REIT’s stock is cheap or dear on an absolute basis, or to determine when REITs as a group are under- or overvalued. Let’s assume that, with this approach, “Montana Apartment Com - munities,” a hypothetical apartment REIT, has an NAV of $20, and, because of good scores in the areas discussed above, the REIT’s shares “should” trade for a 10 percent premium to NAV. Accord - ingly, Montana’s shares would trade, if fairly priced, at $22. If they are trading significantly below that price, they would be considered undervalued and recommended as buys. Those trading at prices significantly in excess of this “warranted value” would be recom - mended for sale. This approach to determining value in a REIT has a great deal of merit, notwithstanding its being difficult and imprecise. It com - F I N D I N G N E T A S S E T V A L U E UNFORTUNATELY, A REIT’S NAV is not an item of information that can be easily obtained. REITs themselves don’t appraise the values of their properties, nor do they hire outside appraisers to do so, and very few provide an opinion as to their NAV. Net asset value is not a figure you will find in REITs’ financial statements. However, research reports from brokerage firms often do include an estimate of NAV. Also, investors can estimate NAV on their own by carefully reviewing the financial statements, asking questions of investor relations personnel, and talk - ing with commercial real estate brokers (or reviewing their websites) to ascertain appropriate cap rates. 215 T H E Q U E S T F O R I N V E S T M E N T V A L U E S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0 bines an analysis of underlying real estate value with other factors that, over the long run, should affect the price investors would be willing to pay for the shares. Since REITs are rarely liquidated, investors should expect to pay less than 100 percent of NAV for a REIT’s shares if the REIT carries excessive balance sheet risk, is managed poorly, is plagued with major conflicts of interest, or is merely unlikely to grow FFO even at the rate that could be achieved if the portfolio properties were owned directly, outside of the REIT. Why pay a premium if the management of the REIT is likely to mis - allocate capital or to otherwise destroy shareholder value? Indeed, a number of REIT shares deserve to trade at an NAV discount. Conversely, investors should be willing to pay more than 100 percent of NAV for a REIT’s shares if the strength of its organi - zation and its access to capital, coupled with a sound strategy for external growth, make it likely that it will increase its FFO, NAV, and dividends at a faster rate than a purely passive, buy-and-hold real estate strategy. This approach to valuation has worked well for Green Street and its clients, as the firm’s track record of forecast - ing over- and underperformance of specific REIT stocks has been excellent. At any particular time, the premiums or discounts to NAV at which a REIT’s stock may sell can be significant. Kimco Realty, for example, since going public in late 1991, has been regarded as one of the highest-quality blue-chip REITs, and its shares have almost always traded at a premium to its estimated NAV. At the end of June 1996, for example, Kimco was trading at a premium of 35 percent to its estimated $20.75 NAV. Conversely, at the same time, an apartment REIT, Town & Country, was trading at a discoun t of almost 20 percent to its $15.50 NAV, because of concerns over its dividend coverage and its anemic growth rate. Eight years later, in June 2004, Kimco’s shares were priced at a 27 percent premium to its estimated NAV of $35.75, but Town & Country’s stock was trad - ing at a 15 percent premium. In this method of valuation, investors should develop their own criteria for determining an appropriate premium or discount to NAV, taking into account not only the rate at which the REIT can increase its NAV, FFO, or AFFO in relation - ship to the growth expected from a purely passive business strategy, but all the other blue-chip REIT characteristics we have discussed. 216 I N V E S T I N G I N R E I T S S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0 Perceived risk, of course, should play a key role in this process. An advantage to this approach is that it keeps investors from get - ting carried away by periods of eye-popping, but unsustainable, FFO growth that occur from time to time. From 1992 to 1994, apartment REITs enjoyed incredible opportunities for FFO growth through attractive acquisitions, since capital was cheap and there was an abundance of good-quality apartments available for purchase at cap rates above 10 percent. Furthermore, occupancy rates were rising and rents were increasing, since in most parts of the country few new units had been built for many years. Since FFO was growing at surprisingly strong rates, analysts using valuation models based only on current FFO growth rates might have had investors buying these REITs aggressively when their prices were sky-high, reflecting potentially huge growth prospects for many years. But, as it hap - pened, growth slowed substantially in 1995 and 1996 as apartment markets returned to equilibrium. Investors who bought stocks of apartment REITs trading at the then-prevailing high multiples of projected FFO never saw FFO growth live up to projections, and, consequently, saw little appreciation in their share prices for quite some time. A similar phenomenon occurred in 1998–99, when external growth slowed substantially for most REITs, and investors who bought in 1997 at very high NAV premiums suffered signifi - cant stock price declines. Using an NAV model may also keep an investor from giving too much credit to a REIT whose fast growth is a result of excessive debt leverage; interest rates on debt are often lower than cap rates on real estate, making it easy for a REIT to “buy” FFO growth by taking on more debt, especially lower-cost variable-rate debt. If only price P/FFO models are used, such a REIT might be assigned a growth premium without taking into account that such growth was bought at the cost of an overleveraged balance sheet. Essentially, an NAV approach that focuses primarily on property values is a valid one and, if used carefully, can help the investor avoid overvalued REITs. We must, of course, remember to apply an appropriate premium or discount to NAV—appropriate being the significant word here—in order to give credit to the value-creating ability (or tendency to destroy value) of the REIT. At times, the abil - ity of creative management to add substantial value and growth 217 T H E Q U E S T F O R I N V E S T M E N T V A L U E S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0 beyond what we’d expect from the properties themselves can sig- nificantly exceed the real estate values; a good example of this may be Vornado Realty, as well as Kimco Realty. Once assigned, these premiums and discounts will change from time to time in response to economic conditions applicable to the sector, to real estate in general, and to the unique situation of each REIT. For example, a larger NAV premium would be warranted during peri - ods in which external growth opportunities are abundant, and vice versa. Most seasoned REIT investors believe that reasonable NAV premiums are warranted under the right circumstances, for example, 5–10 percent; the real debate is over their appropriate size at any particular time. P/ F F O MO D ELS Some investors reject the NAV approach, considering it flawed because a REIT’s true market value isn’t based only on its property assets, and an NAV approach ignores the REIT’s value as a busi - ness enterprise. These investors argue that, since REITs are rarely liquidated, their NAVs are not terribly relevant. If investors wanted to buy only properties, they argue, they would do so directly. These REIT investors are more like common stock investors, who want to judge how much is too much to pay for these active real estate enterprises. If we use P/E ratios to value and compare regular com - mon stocks, the argument goes, we should use P/FFO or P/AFFO ratios to value and compare REIT stocks. This argument has some appeal—much more now than it did many years ago—since today many more REITs are truly businesses and not just collections of real estate. Indeed, most brokerage firms today make extensive use of P/FFO ratios (and P/AFFO ratios) when discussing their REIT recommendations. Furthermore, a number of REIT managements, for example, John Bucksbaum at General Growth Properties, have expressed the opinion that their companies should be valued as operating businesses. Nevertheless, P/FFO ratio analysis has major defects that make it difficult to use as the sole valuation tool, in spite of their being somewhat helpful in comparing relativ e valuations among REITs. They are less helpful still as a measurement of absolut e valuations. [...]... precisely what to invest in, you need to determine why you’re investing you need to define your investment goals If you’re going to need those liquid assets in the next year or two, just sitting on them is probably the best thing to do Put your cash in the bank, maybe in a CD, where you know you’ll have it when you need it Investing whether in stocks, bonds, or REITs is still an uncertain venture It should... variables, including track record, business strategy, balance sheet, conflicts of interest, and other factors SOURCE: BPTHESANS-PLAIN 5/ 12 SMALLCAPS TRACK 50 VALUING REITS AS A GROUP Now that we’ve seen how individual REITs can be valued based on NAVs, P/AFFO ratios, and discounted cash flow and dividend growth models, what about determining whether REITs, as a group, are cheap or expensive? Investors... payments? 5 How important is a steady stream of dividend income? SOURCE: BPTHESANS-PLAIN 5/ 12 SMALLCAPS TRACK 50 AGGRESSIVE INVESTORS SHOULD HAVE MODEST EXPOSURE TO REITS Aggressive investors seeking very large returns over a short period should not put a high percentage of their assets into REITs While it’s true that, on a long-term, total-return basis, REITs have been competitive with the S&P 50 0 index, in. .. without getting clobbered by commissions Suppose, for example, you have $6,000 to invest in REITs If you invest $1,000 each in six different REITs and your brokerage firm has a minimum commission of $50 per trade, your 5 percent commission would cost you virtually all of your first year’s dividend On the other hand, with $30,000 to invest in REITs, six trades would amount to $5, 000 each, and the $50 commission... the short term, REITs are a singles-hitter’s game Very few REIT investments will enable an investor to score a 50 percent gain in one year or rack up a “ten-bagger,” to use Peter Lynch’s expression, within just a few years Some have called REITs the ultimate “un-tech” investment, and their correlation with the Nasdaq Composite Index during the period from January 19 95 through January 20 05 is only 0.17... the REITs we follow, assigning to each its own ratio, based on historical data, and making SOURCE: BPTHESANS-PLAIN 5/ 12 SMALLCAPS TRACK 50 Since the various valuation tools do not always agree, they should be used in conjunction with one another and only as a general indication of whether a REIT stock is cheap or expensive at a specific point in time SOURCE: BPTHESANS-PLAIN 5/ 12 SMALLCAPS TRACK 50 ... yield makes the investor less dependent upon ever-increasing stock prices to fund living expenses SOURCE: BPTHESANS-PLAIN 5/ 12 SMALLCAPS TRACK 50 LOOKING FOR THE “HOLY GRAIL”: THE PERFECT REIT ALLOCATION There are two parts to the question of allocation First, there is the weighting of REITs as an asset class or market sector relative to other investments such as non-REIT equities, international stocks,... guidelines in investing, it’s rare that “one size fits all.” As noted in Chapter 1, adding a REIT component of 20 percent to a diversified investment portfolio, as noted by Ibbotson Associates, can increase investment returns by 0.6 percent annually, while reducing risk by a like amount DIVERSIFICATION AMONG REITS All right, you’ve decided what percentage of your portfolio should be allocated to REITs. .. “exchange-traded funds” (ETFs), which we’ll discuss later in SOURCE: BPTHESANS-PLAIN 5/ 12 SMALLCAPS TRACK 50 I N V E S T I N G 238 B U I L D I N G A R E I T P O R T F O L I O 239 this chapter But now, let’s look at ways to diversify when buying individual REITs SOURCE: BPTHESANS-PLAIN 5/ 12 SMALLCAPS TRACK 50 For most investors, an absolute minimum of six REITs is necessary to achieve a bare-bones level of... little perspective on REITs as investments Almost every book on investing talks about asset allocation: how much of your portfolio should be in stocks (both domestic and international, large cap and small cap, growth and value), how much in bonds, how much in real estate, and how much in cash Some experts say that as you get older you should shift more into bonds and have less in stocks in order to reduce . substantially in 19 95 and 1996 as apartment markets returned to equilibrium. Investors who bought stocks of apartment REITs trading at the then-prevailing high. good-quality apartments available for purchase at cap rates above 10 percent. Furthermore, occupancy rates were rising and rents were increasing, since in most parts