REITs are overvalued and getting riskier.
Prudent investors should exercise caution if considering adding to existing REIT allocations. REITs have been significant performers for three consecutive years as investors have shifted allocations toward income and yield. Not only have fund inflows caused REITS to become overvalued, REITs appear to be getting riskier too as they, like every other investor, move up the yield curve towards more risky real estate assets. A patient wait for better prices, a dollar-cost-average or a half-now, half-later approach might be prudent for future allocations to REITs.
*source: iShares.ca index returns tool
Everybody loves a winner. And good past performance is easy to sell. After three strong years in a row, the headlines are proud to predict a fourth year of out-performance for both US and Canadian REITs in 2012.
Richard Morrison, Feb 3, 2012 Four US REITs to consider NationalPost.com
“A good chance of low double-digit returns for Canadian REITs” – Jonathan Ratner, Jan 26, 2012, No time to be passive, NationalPost.com
Barry Critchley, Jan 26, 2012, Real estate may do an encore, NationalPost.com
Tim Kiladze, Jan 17, 2012 Reit takeovers to be expected in this market, GlobeandMail.com
David Kaufman, Jan 13, 2012, REITs should ride out a housing storm, NationalPost.com
“We expect Canadian REITs could generate average total returns of 15% to as much as 25% in 2012.” – David Pett, Jan 11, 2012, Canadian REITs poised to beat market in 2012, NationalPost.com
Jody White, Jan 11, 2012, In search of top U.S. and Canadian REITs, GlobeandMail.com
Tim Kiladze, Jan 10, 2012 Why REITs could (and should?) keep booming, GlobeandMail.com
Jonathan Ratner, Jan 10, 2012, 10 rules for investing in REITs, NationalPost.com
“REITs are going to outperform next year as well” – Garry Mar, Dec 24, 2011, REITs can be sexy too, NationalPost.com
Strong demand for yield and a dearth of quality properties have increased valuations and reduced cap rates (see below) on real estate across all property types. That demand is coming from … and Institutional sellers are selling to … REITs.
BCA research says the money pouring into REITs over the last couple of years have caused valuations to become elevated.
J.P. Morgan research indicates that REIT yields at or near all-time lows.
The same J.P. Morgan research further says that some real estate transactions are being contracted at a 4.5% cap rate. Think of a cap rate as the inverse of the P/E ratio (or E/P called earnings yield). A 4.5% cap rate equates to a 22 P/E. Not long ago, cap rates were ~6% (or about a 16 P/E).
Investors may be ignoring valuation in their search for yield. It used to be that all yields were not equal. Quality was once a primary valuation measure. (As was leverage). Based on the sub-prime scraps about to be dumped into REIT structures, then sliced and diced and sold off to individual retail investors, one can anticipate ‘well, what did you think you were buying?’ conversations should things go wrong.
US REITs are “are increasingly turning their attention to the market for subprime and other riskier “non-agency” mortgage securities, drawn by high yields relative to the low cost of borrowing”
Telis Demos and Nicole Bullock, Jan 31, 2012, US Reits are drawn to subprime securities, FinancialTimes.com
“We’d like to take Reit path”. The head of Ireland’s National Asset Management Agency has said he would welcome changes in UK legislation that would allow the bad bank to place its €31bn loan book in a real estate investment trust. Brendan McDonagh, who is overseeing the gradual disposal of loans made against 35,000 properties, said that he would be keen to see the introduction of so-called mortgage Reits. The structure, where loans secured against houses, offices and shops, rather than the underlying assets, are put into a Reit, is already commonly used in the US and would give Nama a platform for unwinding its distressed debt. – Ed Hammond, Dec 11, 2011, We’d like to take Reit path, FinancialTimes.com
Scot Blythe, Nov 1, 2011, U.S. Real estate: Priced for perfection? InvestmentReview.com
For potential Canadian REIT investors, there might be one more thing to look at.
The Economist.com has reported on the correlation between the number of skyscrapers being built near the end of real estate booms. A sort of Skyscraper boom / bust index, if you will. The theory is that skyscrapers are blueprinted when money is cheap but cheap eventually gives way to over-leverage and over-building. Currently, there are 173 skyscrapers being built in Toronto as compared to 96 being built in New York. Just saying …
Economist.com Feb 4, 2012, Canada’s Housing market, Economist.com
Economist.com Mar 3, 2011, Bricks and slaughter, Economist.com
“Skyscrapers have long been associated with the ends of financial booms”. – Economist.com Jan 7, 2010, The danger of the bounce, Economist.com
For the prudent investor unsure if strong past performance will repeat in 2012, there are a few different approaches to consider.
Stand-by and wait for a correction, cheaper prices and better valuations.
Buy 1/2 now. ½ Later.
Regardless of the approach, individual investors should avoid individual REITs and instead consider REIT ETFs or index funds.Next time? More Risk Management. Doug Cronk CFA is Manager, Investments for a Canadian Pension Plan