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 The temptation is understandable. REITs, those formed around retail
properties in particular, have been one of the post-financial crisis
stars. The reason: juicy dividends. And, of course, six years of
low-interest rate policy from the U.S. Federal Reserve, which have
pushed bond yields to historic lows.
The S&P 1500 Retail REIT industry group, which includes the likes of
mall and shopping plaza owners Simon Property Group Inc., Macerich
Co. and National Retail Properties Inc., delivered a total return of
nearly 500 percent since March 2009. That's more than double the
return of the wider stock market.
This year alone, the benchmark MSCI U.S. REIT index has surged 26
percent compared with 10 percent for the S&P 500.
Yet, just as Sears Chairman Eddie Lampert considers diving into this
game, fund managers and analysts in the sector worry that the best
days for publicly traded REITs are now behind them because they are
too expensive.
"We're turning over rocks for opportunities, but it's clear that
REITs are not cheap," said Joel Beam, manager of the Forward Income
Opportunity fund.
Beam is not alone. The average equity income fund now holds 7.8
percent of its portfolio in REITs, according to Lipper, the same
percentage as in 2009.
FED THREAT
A top risk for the group is the Fed, which is widely expected to
start raising interest rates next year for the first time since the
recession.
Investors have been drawn into REITs by dividend yields that now
average 3.5 percent, more than a full percentage point above the
yield on safer assets such as the benchmark 10-year U.S. Treasury
note and roughly a half-point higher than the yield on investment
grade corporate bonds.
As such, shares of REITs are highly sensitive to any hint that
interest rates could rise, a prospect that would make bonds more
attractive by comparison.
In 2013, for instance, the S&P 1500 Retail REIT industry group fell
21 percent during the three months of the so-called "Taper Tantrum,"
which erupted following hints by the Fed that it would end its
bond-buying stimulus program - and pivot toward a tighter monetary
policy.
REITs have since recovered to record highs. But analysts say that
rich valuations, at a time when the expanding U.S. economy should
send interest rates higher, mean that another significant drop could
be in the making.
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The group is also substantially more levered than most other stocks.
The average long-term debt-to-equity multiple among the 22 members
of the S&P retail REIT industry group is 143.2 compared with just
94.7 for the S&P 500 as a whole.
Higher interest rates mean higher borrowing costs for new or
refinanced debt, a factor that will further impede profit growth.
To be sure, some analysts say that certain REITs could do well, even
in a rising interest rate environment - largely because they could
pass on costs to their tenants in the form of rising rents.
A lack of new supply in the REIT market, as well as concerns that
the European Union economy is in recession, should keep a floor on
any price declines if rates were to rise, said Alexander Goldfarb, a
senior REIT analyst at Sandler O'Neill.
PRICEY
But even Goldfarb sees valuations stretched for several of the
companies he covers.
Added Todd Lukasik, a Morningstar analyst: "REITs look to be on
average about 10 percent over-valued...what we’ve seen recently is
that on days when you have a big movement upward in the yield of the
10 year Treasury, you get a pretty noticeable decline in REIT stock
prices."
Income fund managers, too, say that they are put off by high
valuations in the sector.
REITs now trade at an average of 23 times cash flow, Beam, the
Forward fund manager said, compared with their historical average of
16 times. Should interest rates rise, he added, it will be "a little
bit scary."
(Reporting by David Randall. Editors: Hank Gilman and Daniel Burns.)
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