2024-01-16 15:16:54 ET
Summary
- Valuation is important for both growth and value investors, and can impact returns and risk.
- Buying REITs when they are cheap relative to the S&P 500 has historically resulted in outperformance.
- REITs are currently cheaper than the S&P 500, making them a potentially better value investment.
Valuation is the core feature of fundamental analysis. All else equal, a cheaper multiple simultaneously makes a stock higher return and lower risk.
Contrary to colloquial perspective, valuation is equally relevant to growth investors as it is to value investors.
For a growth investor this might mean getting the fast-growing stock at a 25X multiple instead of a 30X multiple, and for a value investor it might mean buying assets at 60% of book instead of 80%.
Thus, regardless of one’s investment style, it behooves them to have a strong grasp of valuation in real time. This article will discuss real estate investment trust ("REIT") valuation of the following categories:
- REIT (VNQ, IYR) valuation vs. S&P 500 (SP500)
- Valuation vs. history
- REIT sector level valuation.
REIT valuation relative to S&P
Historically, buying REITs when they are cheap relative to the S&P has resulted in outperformance.
- 2000
- 2009.
Similarly, buying REITs when they are expensive relative to the S&P has resulted in underperformance.
- 2007
- 2021.
The asset classes are different, but the principles of valuation apply to everything.
Today, REITs are once again significantly cheaper than the S&P.
How to compare valuation between asset classes
There is no way to get a perfect value comparison between REITs and the S&P given that they have different primary earnings metrics (Earnings versus Funds From Operations ("FFO")).
With a few adjustments, it will still not be perfect, but rather than comparing apples and oranges, it might be closer to comparing a Honeycrisp apple to a Macintosh.
NAREIT defined FFO as the primary earnings metric for REITs, with the main differences to earnings being that it subtracts gains on sale of property and adds back depreciation. The idea is that well maintained properties tend to hold or even gain value over time, which makes the 30 year depreciation schedule not a relevant metric for earnings.
In more recent years, the analyst community has preferred the metric AFFO to FFO because Adjusted FFO subtracts maintenance capex. This is a real expense and should be subtracted.
Thus, we will be looking at AFFO multiples when comparing to the S&P. Overall, I think a 15X AFFO multiple is quite comparable to a 15X price to earnings ratio. There have been periods in which REIT AFFO multiples have been higher than the S&P earnings multiples, and periods in which they are lower.
Here is where the multiples sit today. S&P data from FactSet and REIT data from S&P Global Market Intelligence.
- S&P: 19.2X forward earnings multiple
- REITs: 14.6X forward AFFO multiple.
Beyond the earnings metric being different, there is a key difference in the methodology by which the multiple is calculated. The S&P multiple is what is called a harmonic average. Analysts calculate the earnings of the individual constituents, which works out to be about 244, and that is compared to the price of 1 share of the S&P around 4736 (calculates closer to 19.4X rather than the reported 19.2X, but the difference is just timeframe as the S&P moved a percent or so).
That, in my opinion, is the correct way to calculate an earnings multiple for an index.
REITs are woefully underfollowed by Wall Street, making reporting on REIT index valuation hard to come by. When it is reported, it is just a simple average, in this case the median, which is the 14.6X figure posted above.
So, to make this a cleaner comparison between REITs and the S&P, we need to convert the REIT multiple into a harmonic average, which is done through converting to earnings yield, averaging, and then converting back to a multiple.
Within REITs, AFFO multiples range from 3X to 88X. AFFO yield is the inverse of the multiple. That 88X REIT is contributing almost none of the AFFO of REITs, while the 3X AFFO REITs produce a larger share of the earnings. In aggregating the AFFO production of each REIT with a 2024 consensus estimate, the average AFFO yield is 7.35%.
Converting back to multiple, we get a (100/7.35=13.6), which represents a multiple of 13.6X.
Now we have the REIT multiple in the same harmonic average format as the S&P multiple. This takes it to:
- S&P 19.2X forward earnings
- REITS 13.6X forward AFFO.
Multiple relative to history
Beyond looking at current multiples, I like to get perspective by seeing how it compares to history.
Ideally, this analysis would be done on AFFO, but index level AFFO multiples are not readily available over the 10 year span. FFO will serve as the proxy, but since FFO and AFFO maintain a similar relationship over time, the same should hold true for AFFO.
REITs are a bit cheaper than they have been for most of the last 10 years. The Dow Jones Equity REIT index currently trades at 15.65X forward FFO. The 5 year average is 17.17X and the 10 year average is 16.23X
2MC
In contrast, the S&P is more expensive than it has normally been.
According to a FactSet report dated January 5 th :
“The forward 12-month P/E ratio for the S&P 500 is 19.2. This P/E ratio is above the 5-year average (18.9) and above the 10-year average (17.6).”
The multiple of the S&P has expanded materially, with most of the increase happening in the last year. S&P traded up about 22% while earnings estimates declined.
The net result is a forward P/E ratio above historical averages
Valuation within REITs
While REITs as a whole are at a below average multiple, there is quite a bit of variance within. Certain property sectors are clearly in and out of favor. Here are the multiples of each major property sector:
2MC using data from S&P Global Market Intelligence
Most of these price differences make sense to me. Strong growth sectors like industrial and single family rental should indeed trade at higher multiples than weak sectors like office or hotels.
Investors are presented with the challenge of deciding how much more they are willing to pay for the better assets. I find it helpful to look at the differences in percentage terms, specifically the premium or discount to the median multiple.
2MC using data from S&P Global Market Intelligence
A few of these sectors strike me as mispriced; Specifically, office, triple net and industrial.
- Industrial is higher growth, but is it fast enough growth to justify paying a 62% premium?
- Office is widely known to be fundamentally struggling with high vacancy. A 7% discount doesn’t seem like enough.
- Triple net REITs have great visibility into future cashflows and often trade at a premium multiple to the REIT average. The 12% discount seems opportunistic
This data is meant to be a starting point for analysis. It might be useful to inform asset allocation between asset classes, but should be followed up by company specific analysis.
The take-home message
REITs appear to be a better value relative to both themselves and the S&P 500 as compared to historical norms.
For further details see:
2024 REIT Valuation Analysis