Saturday, February 12, 2005

Prospecting for Outliers Among REITs (II)

Because the value of a real property company derives primarily from land, buildings and other "bricks and mortar" factors (instead of brand, image and other "soft" variables), REITs are a much more homogeneous group than their counterparts in manufacturing, technology, retailing, the financial sector, etc. This tends to make the search for "outliers" (i.e., valuation misfits) among REITs a little easier.

A quick examination of simple valuation ratios can often reveal buying opportunities, resulting from a selloff (market overreaction) that makes a REIT cheap relative to its peers, even though the core business of leasing out space to tenants is basically the same. Undervaluation of a REIT's shares typically corresponds to a "disconnect" between management and Wall Street--missed targets, lack of visibility, overzealous acquisitions, operating problems, etc.--usually with only a temporary impact on reported earnings. The underlying real property that a REIT owns provides a very solid "floor" on the value of a REIT's shares. Upside for the investor comes with share price recovery when management is able to bring an underperforming real property portfolio back in line with the operating performance of properties of its peer REITs--something that is a lot easier to do with "hard" real estate assets than with "soft" intangibles.

Across the main REIT sectors, recent share performance and look-ahead valuation ratios are:

(Data from

REIT Sector: Total Return 2003, Total Return 2004; P/FFO 2005

Office and Industrial
Office: 34%, 23%; 13.0
Industrial: 33%, 34%; 15.7

Shopping Centers: 43%, 36%; 14.1
Regional Malls: 52%, 45%; 13.3
Free Standing: 36%, 33%; 14.1

Apartments: 25%, 35%; 15.9
Manufactured Homes: 30%, 6%; 13.3

Self-Storage: 38%, 29%; 15.4

In our prospecting for outliers, two sectors stand out:

1. Office: From a "quality" perspective, the office sector with its desirable Class A properties in metropolitan centers should trade "richer" than the other REIT sectors. However, with the economic recession and dotcom fallout of 2001-2002, office occupancy fell sharply to around 85% nationwide and has only recently begun to recover. Indicative of a submarket undergoing recovery, the office REIT forward P/FFO ratio of 13.0 is the lowest among the sectors displayed above, though followed closely by regional malls and manufactured homes (both 13.3). Also, the office REIT total return of 23% for 2004 was the second lowest among the REIT sectors last year;

2. Manufactured Homes: The total return of 6% for 2004 was by far the lowest among the sectors, following a 30% total return performance in line with other sectors for 2003. The sector weakness last year was largely due to a decline in occupancy rates, as low interest rates have encouraged a number of tenants to vacate manufactured home parks and "move up" into affordable stick-built homes instead.

Let's now take a quick look at particular REITs in these two sectors:

(Data from

In the office sector, the largest REITs are:

Company (Ticker): Market Capitalization, Forward P/FFO , Price/Sales, Price/Book

Equity Office (EOP): $12.3 bil., 11.8, 3.9, 1.3
Boston Properties (BXP): $6.6 bil., 14.1, 4.8, 2.3
Trizec Properties (TRZ): $2.8 bil., 11.0, 4.0, 1.5
Mack-Cali Realty (CLI): $2.7 bil., 12.2, 4.7, 1.8
Arden Realty (ARI): $2.3 bil., 13.3, 5.6, 2.0
SL Green (SLG): $2.3 bil., 13.7, 6.6, 2.3
HRPT Properties (HRP): $2.2 bil., 9.9, 3.9, 1.2

The most prominent name with the largest portfolio of prime Class A office buildings in major U.S. cities is Sam Zell's Equity Office Properties. Equity Office, Trizec and HRPT currently have attractive forward P/FFO (11.8, 11.0 and 9.9), P/S (3.9, 4.0, 3.9) and P/B (1.3, 1.5, 1.2) ratios. Though HRPT looks cheaper by these measures, I favor Equity Office and Trizec because of their larger concentration of high quality office properties in primary urban cores. As occupancy in the office market continues to recover from its nadir in 2003, I expect multiple expansion in the office sector, with the forward P/FFO ratio for office REITs rising relative to other sectors and, in particular, Equity Office and Trizec "catching up" to and outperforming their office sector peers. (Disclosure: I have owned both EOP and TRZ for a few years and continue to hold.)

In the manufactured homes sector (which is much smaller than the office sector), the three largest REITs are:

Company (Ticker): Market Capitalization, Forward P/FFO, Price/Sales, Price/Book

Equity Lifestyle (ELS): $800 mil., 14.0, 2.9, 18.3
Sun Communities (SUI): $670 mil., 12.2, 3.4, 3.1
Affordable Residential Communities (ARC): $510 mil., 10.6, 2.5, 0.87

Equity Lifestyle (run by Sam Zell) is the largest in the sector by market capitalization. However, through a series of acquisitions completed prior to their IPO in February 2004, ARC rapidly has become the manufactured home REIT with the greatest number of manufactured home homesites (Note: Equity Lifestyle also owns RV spaces, giving it a larger number of combined MH and RV sites). ARC is the cheapest of the three when measured by forward P/FFO (10.6), P/S (2.5), and P/B (0.87). The price/book ratio below parity is particularly attractive.

A glance at the value per homesite shows:

Company: Enterprise Value; Number of Homesites; Value Per Homesite

Equity Lifestyle: $2.3 bil.; 57,000 (+ 44,000 RV spaces); $40k (MH only) to $23k (MH + RV)
Sun: $1.6 bil.; 47,000; $34k
ARC: $1.6 bil.; 67,000; $24k

Since RV spaces are worth less than manufactured home homesites, ARC is the cheapest of these three REITs by value per homesite.

Appearing undervalued by all of these quick measures--forward P/FFO, P/S, P/B and value per homesite--ARC deserves a closer look. I will examine this potential buying opportunity in my next post.


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