If You Must Own REITs...

To the lengthening list of reasons to distrust real estate securities, please allow me to add one more: merger and acquisition (M&A) activity is picking up in the REIT sector.

Shortly after M&A activity in a given industry heats up, the industry often becomes stone cold. …especially if the acquirers are paying for their acquisitions with stock instead of cash.

I had this very thought in mind when I urged the subscribers of my Fleet Street Letter to take profits on Catellus, which ProLogis recently acquired. REITs have enjoyed an amazing five-year run, as the chart below clearly illustrates. The MSCI REIT Index has more than doubled since 2000, compared to break-even or negative returns from the broader market indexes.

Not surprisingly, therefore, M&A activity has picked up dramatically. Last year, for example, there were 14 REIT acquisitions, worth a total of nearly $20 billion. So far in 2005, the blistering pace continues, with seven transactions pending or completed. The acquisitions continue, despite that fact that few values remain in the REIT sector.

Keven Lindemann, director of real estate research at SNL Financial, points out that almost all of the 128 publicly traded REITs he follows carry very rich valuations. Of these publicly traded REITs, only 17 trade at a discount to their net asset value (or NAV, which represents an estimate of the value of the underlying real estate a REIT owns). And of these 17, only five of them sell for more than 10% below their NAVs. The nearby chart presents this select group.

On a net asset value basis, these are the cheapest REITS on the market. When I recommended Catellus, it was trading at a discount to my estimate of its NAV. ProLogis acquired it within eight months. Similarly, these REITS would seem to be good candidates for acquisition. If you must own REITS, this is as a good list to start your research with as any.

Keep in mind that in the REIT world, hostile takeovers are rare. That’s because insiders often own a good chunk of stock and can block acquisitions they don’t support. Most REIT acquisitions happen with the aid of willing management and an amenable board of directors.

It’s interesting to note that the NAV discounts themselves do not appear all that large. There are only two companies in the table above with a discount larger than 20%. On the flip side, many REITS trade at substantial premiums to NAV. Below is a table that compiles the REITS with premiums to NAV of at least 35%:

NAV is not the end-all of REIT analysis, but it’s a good place to start. And now that so many REITS sell for prices well above their NAVs, the sector would seem to offer less reward than risk. What’s more, the fact that so many REIT managements are taking advantage of their inflated share prices to acquire other REITs is another worrisome sign. For those of us who use dollar bills to conduct our investment activity, buying an almost cheap stock is no better then eating an almost fresh fish.

Unfortunately, the values available in the REIT sector aren’t quite as fresh as they used to be…or ought to be.

And the Markets…

  

Wednesday 

Tuesday 

This week 

Year-to-Date 

DOW  

10,551  

10,513  

-50 

-2.2% 

S&P 

1,220  

1,219  

-10 

0.7% 

NASDAQ 

2,145  

2,137  

-12 

-1.4% 

10-year Treasury 

427.00% 

4.21% 

422.75 

422.78 

30-year Treasury 

447.00% 

4.42% 

442.55 

442.18 

Russell 2000 

655  

655  

-5 

0.5% 

Gold 

$439.88  

$446.05  

-$6.32 

0.5% 

Silver 

$6.99  

$7.03  

-$0.09 

2.6% 

CRB 

313.66  

319.59  

-9.30 

10.5% 

WTI NYMEX CRUDE 

$63.25  

$66.08  

-$3.61 

45.6% 

Yen (YEN/USD) 

JPY 110.00  

JPY 109.57  

-0.61 

-7.2% 

Dollar (USD/EUR) 

$1.2267  

$1.2358  

172 

9.5% 

Dollar (USD/GBP) 

$1.8059  

$1.8102  

83 

5.9% 

The Daily Reckoning