In response to an earlier post on iShares CDN REIT Sector Index Fund (XRE), some readers were interested in the historical risk and return characteristics of REITs. David Swensen writes in Unconventional Success that real estate is riskier and more rewarding than bonds and has less risk and lower returns than equities:

Shorter-term data on market returns confirm the notion that real estate sits between stocks and bonds in risk and return characteristics. Returns covering the quarter century from 1978 to 2003 for an index of marketable real estate securities stand at 12.0 percent per annum, poised between the 13.5 percent per annum return for the S&P 500 and the 8.7 percent per annum return for intermediate-term U.S. Treasury bonds.

Publicly traded REITs have an interesting attribute: they trade at prices that are sometimes significantly different from fair value:

At one point in 1990, by Green Street’s estimate, real estate securities traded at more than a 36 percent discount to fair value. By 1993, the stock market reversed itself, valuing real-estate-related holdings at a 28 percent premium to fair value. The yin and yang continued. In late 1994, the discount reached nine percent, while in 1997, stock market investors paid more than a 33 percent premium to fair value. In the late 1990s, a poor market for real estate securities (that coincided with a wonderful market for most other securities) brought valuations to a deficit of more than 20 percent, a level reached in early 2000. As the non-real estate portion of the market entered bear territory, real estate securities took on bull characteristics, leading to a greater than 22 percent premium to fair value in early 2004.

Though the data used in the book is based on U.S. based REITs, there is no reason to think that the market is very different in Canada. It would be interesting to find out fair value data for Canadian REITs to initiate or add to REIT positions when they are trading at a discount to fair value. Do you know where we can obtain such data?

This article has 15 comments

  1. I’m eagerly waiting for someone to respond to this post. How does David Swensen figure out the fair market value for American REITs anyway? Can we follow the same valuation matrix?

    BTW, your RSS subscription reaches the 1,000 milestone. Real estate is going up up up here.

  2. Canadian Capitalist

    FJ: I don’t think David Swensen explains how he obtained data on fair value (I’ll check the references section later today). It would be very nice if we can simply read the NAV off some analyst report.

  3. One thing that probably isn’t included in the assessment is that most junior REITs have distributions which are fully tax-free as long as you never sell the investment. The reason is because the depreciation for tax purposes is larger than the AFFO, so the distributions are 100% classified as return of capital. So, a 9% tax-free yield is like making about 15% on an after-tax basis if you’re a wage slave at the marginal tax rate (like me). In my opinion, it’s pretty darn hard to beat a 15% after-tax annual return with common equities!

  4. Canadian Capitalist

    Phil: It is true that ROC is not taxable but it reduces your adjusted cost base. So when you eventually sell it (assuming the stock is selling at the same level), you’ll pay capital gains tax. Once your ACB is 0, you probably will have to pay tax on ROC as well (not sure, have to check up on this). Still, ROC does allow you to defer tax and even for XRE, in some years, as much as 50% of the distributions are ROC.

  5. Congrats on reaching the milestone 1000 RSS subscribers CC! Great job as usual!

  6. Hi CC. But that’s exactly my point. If you hold the REIT units basically forever until you die (ie. never sell it), then for all intents and purposes, you can consider the current distributions to be tax-free for most junior REITs and maybe 50% tax free for some of the slightly older REITs.

    I always look at things on an after-tax basis and that’s one of the reasons why I really like REITs! Especially considering that I hold Warren Buffett’s philosophy of having an investment time horizon of “forever”. In that case, all of the monthly distributions are tax-free or at least partially tax-free money! And in our environment of ridiculously high personal income tax rates – that’s definitely a GOOD thing! =0)

  7. Congrats on having a 1000 subscribers! I’m still working on my first 100.

    Does anyone know Swenson’s email??

    Mike

  8. If the distribution is 10% — all of which ROC — the ACB will fall below $0 after 10 years assuming no distribution increases.

    Any subsequent distributions are then taxed as capital gains with no deferral. That’s my understanding.

  9. Larry Anderson

    The risks and returns of Canadian REIT’s vary widely depending on a number of factors, including but not limited to: the quality of the underlying real estate, the quality and diversification of the tenants, the term of the tenancy and, of course, the quality of the management. Both Standard and Poors and the Dominion Bond Rating Service provide ratings for the best REIT’s, like Riocan, H.R. REIT and others. Most manjor Canadian brokerages provide research and analysis.

    A quality Retail REIT, like Riocan (REI.UN-T), has the benefit of having a large number of high quality national tenants with long term leases and matches their financing terms to lease terms, oftern 10 years or more with options. This is good for stability but locks in lower lease rates during rising markets.

    Apartment and hotel REITS allow the managers to increase rents more quickly if the market allows but in poor markets the tenants can vacate more quickly and the financial commitment of the tenants is more tenuous. More upside and less stability.

    In addition, REIT’s are currently trading at very high prices with low yields compared to their historical prices and returns.

    I am a happy long term holder of Riocan and the REIT index, and I will continue to hold what I have, but I will not purchase more at these prices. Why? REIT’s respond negatively to rising interest rates and I believe they are fully valued.

  10. I find one can really get bogged down in semantics when talking about “fair value” . I mean, in an allegedly free market like the one we have, isn’t every security fairly valued at all times?

    You can jump up and down and scream about a stock being undervalued all day long, but at the end of the day, if you don’t like what the market is offering, you have two options: sell for less than you think its worth, or wait it out. Being a “value investor” I generally wait it out. More often than not I’m proved right.

    But that said, I think the underlying principle of your post is a good one — people tend to value real estate investments in vastly different ways over time. The fact that a REIT is worth 100% more today than it was in 2003 has as much to do with how real estate is perceived as it does with any improvement in the underlying asset’s fundamentals.

    The exact same apartment building with the exact same tenants paying the exact same rent will look different depending on what else is going on in the world.

    But make no mistake, that pendulum swings back.

  11. Larry Anderson

    The most successful investor in history, Warren Buffet, calculates the intrinsic value of any security he buys. Buffet likes to buy securities at a 25 percent to intrinsic value.

    To be able to calculate the intrinsic value requires the ability to forecast future earnings for a company with confidence and then either discount earnings (Buffet) or cashflow (Morningstar) to arrive at intrinsic value.

    If you can’t forecast future earnings with confidence you can’t calculate intrinsic value.

    If you don’t know what something is worth how can you determine if it is a good investment? Warren might ask, “would you buy a new car without figuring out what it was worth before negotiating the purchase?”

  12. Canadian Capitalist

    Fair value or intrinsic value is difficult to calculate for stocks but for real estate it is simply the replacement cost of buildings plus the value of the land. Time to read RioCan annual reports to see if we can dig up something.

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