Are REITs Now Undervalued?
September 8, 2009
by Geoff Considine, Ph.D.
With such a diversity of REITS, differences in leverage are one significant factor (see here). Adding leverage to a REIT allows it to generate bigger returns—but also results in substantially increased risk and a higher Beta. At a recent NAREIT (National Association of REITs) conference, a consensus emerged that less-leveraged REITs will emerge as the dominant player in coming years. Not surprisingly, there is a positive correlation between leverage and market-to-book ratio: Highly-leveraged REITs tend to have high market-to-book ratios, while less leverage means lower ratios. This measure can provide some basis for differentiating between REITs, but I have found that other statistics have considerable value as well.
One useful question, for example, is which variables, if any, could have helped flag the REITs and REIT indexes that were most vulnerable to the 2007 real estate crash. By analyzing the above REITs through July 2006, I discovered which variables were the best predictors of loss. The half of these funds with the highest Betas at that time generated returns substantially better than the half with lower Betas—a difference of about 15% per year in the subsequent three-year period. The high-Beta REITs and REIT funds had slightly higher trailing volatility than their low-Beta counterparts, a result that seems somewhat paradoxical. When the broader market declines, high-Beta investments are expected to decline more than low-Beta investments. To investigate this further, I separated the half of these REITs and REIT funds with the highest Betas from those with the lowest Betas (as of July 2006) and analyzed them as two separate portfolios in a portfolio Monte Carlo simulation (Quantext Portfolio Planner).
Monte Carlo projections for low Beta REIT’s (through July 06)
This portfolio, with equal weights to the low-Beta REIT’s, exhibited very high trailing returns as of 7/31/2006—the trailing return and volatility are very close to the results for the REIT funds cited earlier. Note that the Monte Carlo projected returns are considerably lower than the trailing returns (by about 5% per year: 18.25% vs. trailing return of 23.15%) and the projected volatility is twice the trailing volatility. By March of 2007, my Monte Carlo projections were that REIT’s were vastly over-valued.
Monte Carlo projections for high Beta REIT’s (through July 06)
The high-Beta REIT portfolio had a July 2006 Beta of 1.1 vs. .78% for the low-Beta case. The high-Beta REIT portfolio had a significantly higher yield and almost double the R-squared (relative to the S&P500) of the low-Beta portfolio. QPP also suggests that the low-Beta portfolio is more overvalued than the high-Beta portfolio.
Low-Beta Excess Returns = 23.15% - 18.25% = 4.90% per year
High-Beta Excess Returns = 22.01% - 19.05%= 2.96% per year
As of the end of July 2009, both of these portfolios had trailing three-year Betas of about 1.40 and R-squared values of 60% relative to the S&P500.
The difference between trailing returns and expected returns is an important tactical variable (see here). Asset classes that have returned considerably more than their expected returns are likely to revert to the mean and deliver lower returns (and vice versa). Reversion to the mean was one of the big warning signals going into late 2007 and 2008. Even among REITs, I have noted that the high-Beta REITs as a group were less over-valued on this basis than the low-Beta REITs. I sorted all of the REITs and REIT funds just based on the difference between trailing three-year return and QPP expected returns using data through July 06, and I found that REITs that were under-valued (expected return greater than trailing three-year return) out-performed REITs that were over-valued (expected return less than trailing return) by 9.3% in average annual return over the next three years.
The real estate bubble was obviously driven by dynamics that were at work for more than just the last three years, so I generated QPP projections using ten years of trailing data (through July 2009) and compared the expected return to the trailing ten-year return for all of the REITs and REIT funds that had at least ten years of data available. The results were striking. The trailing ten-year average return for all of the REITs in our sample was 14.1% (arithmetic average annual return). The expected average annual return for the REITs from the Monte Carlo simulation was 14.0%. In other words, REITs as a group were more or less fairly valued at the end of July 2009. There is, however, quite a spread within the asset class—some REITs look under-valued and some look over-valued on this statistical basis.