Another Way To View The Current Valuation Of REIT Sector

In our February issue, we included an article on the REIT sector and included three charts which were kindly provided by the Leuthold Group.  This month, we are reprinting an excerpt from The Heitman Perspective (the newsletter of The Heitman Real Estate Fund, www.heitman.com) .  We thought our readers would very much appreciate the analysis provided by the Heitman management team.

The chart below presents a historical analysis of various valuation metrics since 1997.  While debt to total capitalization levels remain in the low 40% range, cash flow payout ratios have continued to erode modestly.  During the first quarter, the “cash flow available for distribution” (CAD) payout ratio for real estate stocks increased to 86.3% from 83.2% at year end 2004.  The eroding payout ratio reflects high leasing costs as well as the increasingly complex accounting conventions which require the recognition of non-cash revenue adjustments.  As real estate fundamentals improve, leasing costs should begin to come down while cash flows increase.

During the first quarter, the dividend yield for real estate securities increased by 50 basis points.  This coincidently matched the rise in the Fed Funds rate, which increased to 2.75% at the end of the quarter from 2.25% at the end of 2004.  However, the yield on real estate securities continues to be well below its historic average.

While cash flow multiples moderated during the first quarter, they remain above historic pricing levels.  The average 17.8 times CAD multiple implies an average earnings yield of 5.62%, which is well below the yield on the Baa corporate bond of 6.07% at quarter end.  Absent investor’s expectations for accelerating earnings and dividend growth for real estate securities, this would imply better value in corporate bonds on a current basis, excluding any capital appreciation in REITs from expected growth in cash flow per share.

While real estate securities are expected to increase cash flow by 5.8% in 2005, the price investors are paying for that growth is high relative to historic valuation measures.  For example, the Multiple to Growth Ratio is the relationship between the growth and earnings multiple.  Currently, investors are paying 2.63 multiple points for every 1% increase in growth.  As shown below, that ratio in 1998 was almost even at 1 multiple point for each 1% increase in growth.  While this ratio has been declining in recent years, the multiples investors are paying remains historically high.

                                                   December 31                                                 1Q

	1997	1998	1999	2000	2001	2002	2003	2004	2005
Debt-to-Total Capitalization	31.1%	44.0%	50.6%	47.2%	48.4%	50.3%	45.0%	41.7%	43.9%
CAD Payout Ratio1	69.0%	65.3%	65.9%	62.6%	64.3%	75.3%	80.1%	83.2%	86.3%
Dividend Yield	4.9%	6.4%	7.6%	6.4%	6.2%	6.7%	5.3%	4.4%	4.9%
Cash Flow per Share Growth2	18.1%	11.8%	9.3%	9.1%	5.1%	1.2%	4.4%	6.8%	5.8%
CAD Multiple1	14.8X	10.5X	9.0X	10.2X	10.7X	11.4X	15.5X	19.1X	17.8X
Multiple to Growth Ratio1, 2	1.10	1.02	1.13	1.26	1.73	2.09	2.75	2.69	2.63

Note:  Dow Jones Wilshire Real Estate Securities Index.  The above numbers are averages weighted by market capitalization.

¹  Estimated next year cash available for distribution.

²  Expected growth rate for succeeding year compared to current year.

Capital flows into real estate, particularly into the private market remains very high.  As a result, there is far more capital looking to invest in real estate than there is currently property for sale.  This imbalance has resulted in a dramatic reduction in capitalization rates, or the going-in yield private market buyers are willing to accept.  As a result of applying current market capitalization rates on the real estate income of the public market companies, it appears that the public real estate companies are trading at a slight discount to current private market valuations.