Stock Market Rotations and REIT Valuation

For much of the past decade, ALTHOUGH PUBLIC debate over the true nature of real estate stocks has public real estate companies waned since the explosive growth phase of the real estate investment trust (REIT) have behaved like small cap market in the mid-1990s, the strong per- formance for real estate stocks in 2001 and value stocks. the first half of 2002, even as property mar- ket fundamentals weakened, has refocused attention on the relationship between pub- lic and private real estate markets. Despite rising vacancy rates and falling rents across virtually all property types and markets in the United States, real estate stocks outper- formed both the broader public equities market and private real estate in 2001 and early 2002. Many real estate companies, in ROBERT FALZON

22 ZELL/LURIE REAL ESTATE CENTER fact, were trading at slight premiums to the have exerted a powerful influence on the net asset values (NAVs) of their underlying valuation of real estate stocks. At times, properties for some or all of this recent this influence has overwhelmed property period. While not all REITs participated in market fundamentals, resulting in episodes the market rally, the recent period contrasts during which property market conditions sharply with the 1998 to 1999 period, and REIT performance have differed dra- when public real estate companies posted matically, causing public companies to negative returns and traded at steep dis- trade at discounts or premiums to their counts to NAV, while private real estate NAVs. This article examines the relation- investments, as measured by the NCREIF ship between public market investor senti- Property Index (NPI), enjoyed healthy ment and valuations of public real estate double-digit returns. companies. It finds that shares of public The periodic disconnects between the real estate companies have behaved like valuations of public real estate companies, small cap value stocks for much of the past both REITs and real estate companies decade and, as such, have tended to trade (REOCs), and the conditions in the prop- at premiums to NAV when market senti- erty markets have puzzled investors and ment favors value stocks and at discounts analysts, fueling the debate over whether to NAV when market sentiment favors public real estate companies are real estate growth stocks. or stocks. Although many in the industry have conceded that REITs and REOCs are both, the relationship between the private THE PRICE-TO-NAV PUZZLE property markets and public equities mar- ket is not well understood. Some analysts, To understand the relationship between for example, have interpreted the REIT the public and private real estate markets, market decline in 1998 and 1999 and the analysts and investors often examine the subsequent recovery as evidence that the ratio between public companies’ share forward-looking public markets lead the prices and their NAV per share estimates. backward-looking private markets, antici- When price-to-NAV ratios are less than pating dislocations in the space markets. one, companies trade at discounts to NAV; While property market fundamentals when price-to-NAV ratios are greater than clearly affect the performance of REITs one, companies trade at premiums to and REOCs, we believe that rotations in NAV. Figure 1 shows that REITs generally public market sentiment between growth- have traded at prices differing from NAV, oriented stocks and value-oriented stocks most often within a band around NAV

REVIEW 23 ranging from a 20 percent discount to a 20 issue of why REITs as a group tend to percent premium. Since 1990, there have trade at values different from NAV. Two been three distinct periods during which theories have tried to explain the pricing REITs traded at premiums to NAV and differences in the public and private prop- two distinct times when they traded at dis- erty markets. The closed-end fund theory counts to NAV. views REITs primarily as passive portfolios

Figure I REITs Usually Trade at Values Different from NAV

REIT Price Relative to Net Asset Value (NAV) 60

40 DiscountPremium? Premium Discount

20

0

-20 Premium

-40 REIT Price/NAV (trailing 3-mo avg)

-60 1Q90 3Q90 1Q91 3Q91 1Q92 3Q92 1Q93 3Q93 Sep-94 Sep-95 Sep-96 Sep-97 Sep-98 Sep-99 Sep-00 Sep-01 Mar-94 Mar-95 Mar-96 Mar-97 Mar-98 Mar-99 Mar-00 Mar-01 Mar-02

Source: Green Street Advisors; PREI

Many academic and industry studies that allow small investors to invest in a have attempted to determine what factors diversified portfolio of real estate assets have driven the disparities between the val- without the complications of operating uations in the two markets. Our own prior responsibilities. Closed-end funds tend to research, which looked at the determinants trade at a discount relative to their NAVs. of REIT valuations relative to other Thus, the theory predicts that REITs REITs, suggests that earnings growth, size should be priced at a discount relative to (market capitalization), and leverage have NAVs, at least most of the time, which been important drivers of pricing disper- clearly contradicts observed facts. sions between REITs. Imbedded tax costs, uncertainty with valu- Most studies do not address the macro ing underlying investments, and serious

24 ZELL/LURIE REAL ESTATE CENTER agency problems coupled with limited of finding and executing effective invest- ability to add value in relatively efficient ment and operating strategies. Ultimately, public markets are the major factors con- such a framework predicts a market char- tributing to the discount pricing of acterized by relatively few, large, and effi- exchange-traded closed-end funds. cient companies dominating the industry, The operating-company theory sug- allowing the successful companies to trade gests just the opposite—that REITs should at premiums to their underlying NAVs. trade at premiums to NAV. It views REITs as operating companies that actively pur- sue investment opportunities to add value REITS AND SMALL CAP to the company. According to this theory, V ALUE STOCKS successful REITs should be able to attain strong and sustainable growth rates. In While the operating-company theory is competitive capital markets, the good probably a more accurate description of companies will have a lower cost of capital most REITs and REOCs today, the histor- and will force out the inferior companies ical patterns in REIT price-to-NAV ratios whose management teams are not capable suggest that neither theory explains the

Figure 2 Strong Relationship Between REITs and Small Cap Value Stocks

Rolling 60-Month Correlation With Equity REITs

1.00

0.90

0.80

0.70

0.60

0.50 With S&P 500 0.40 With Russell 2000 With Russell 2000 Value 0.30

0.20

0.10

0.00 Jul-90 Jul-91 Jul-92 Jul-93 Jul-94 Jul-95 Jul-96 Jul-97 Jul-98 Jul-99 Jul-00 Jul-01 Jul-02 Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02

Sources: Ibbotson Associates; PREI

REVIEW 25 pricing differences between public real 500. The correlation between REITs and estate companies and private market valu- the Russell 2000 has been consistently ations of their assets. Instead, a cyclical pat- higher than the correlation between tern of REIT pricing frequently moves REITs and the S&P 500, which has independently of property market cycles declined over time from more than 0.70 in and seems to be more closely related to the early 1990s to around 0.30 today. investor sentiment in the public equities This relationship is not surprising, market. since most REITs and REOCs have equi- Figure 2 shows the correlations ty market capitalizations that are typical between REITs and the S&P 500, Russell of small to medium cap stocks in the 2000, and Russell 2000 Value indices. U.S. stock market. Figure 3 demon- REITs clearly have more in common with strates the small cap nature of REITs rel- smaller cap stocks, represented by the ative to companies in the S&P 500. As of Russell 2000 indices, than they do with September 30, 2002, the companies in large cap stocks, represented by the S&P the S&P 500 had an aggregate market

Figure 3 Most REITs are Small Cap Companies

Size Characteristics of S&P 500 Companies vs. REITs S&P 500 REITs Number of Companies 500 177 Total Market Value 7,437,578 163,194 Average Market Value 14,875 922 Weighted Average Market Value1 71,095 2,935 1st Quartile 12,549 1,150 Median 6,309 415 3rd Quartile 2,857 149 Maximum 245,254 10,820 Minimum 238 1 Number of Companies Less Than $1 Billion 23 125 Overall Capitalization Status 2 0.93 0.27

Market value data in millions, as of Sept 30, 2002

1 Weighted by the market value share. 2 Individual companies have a capitalization status ranging from 0 to 1. Companies with a market cap of $8 billion or more are assigned a status indicator of 1. Companies with a market cap of $1 billion or less are assigned a status indicator of 0. Companies with a market cap between $1 billion and $8 billion have a status indicator between 0 and 1, linearly interpolated according to their market value. The overall capitalization status is a weighted average of the individual market cap status indicator, the weight being market value share of the company.

Sources: Datastream; NAREIT; PREI

26 ZELL/LURIE REAL ESTATE CENTER value of nearly $7.5 trillion and an aver- included in the S&P 500 have limited age value of just under $14.9 billion. By influence in the overall index. At the same comparison, the 177 REITs in the time, not all REITs are small cap stocks NAREIT Index had an aggregate market either. The largest REIT has more than value of just $163 billion, and an average $10 billion in equity capitalization. But size of just $922 million. the overall capitalization status of the Assuming that companies with more NAREIT members is 0.27, which could than an $8 billion equity capitalization are loosely be interpreted as 27 percent large squarely large cap stocks and those with cap and 73 percent small cap companies. less than $1 billion are squarely small cap Within the small cap universe, REITs stocks, the overall capitalization status of are more highly correlated with small cap the S&P 500 is 0.93. (A status of “one” is value stocks than they are with the broad- 100 percent large cap.) Although the S&P er Russell 2000 index, which includes 500 is a large cap index, it does not repre- small cap growth stocks as well. Again, this sent the largest 500 companies traded in is not terribly surprising, given the high the U.S. stock markets. However, as the dividend yields that most REITs offer overall capitalization status suggests, the investors. While the correlation between medium to small cap stocks that are REITs and the Russell 2000 index has

Figure 4 REIT Returns Track Small Cap Value Stock Returns

Trailing 12-Month Total Returns (%) 60.0

50.0

40.0

30.0

20.0

10.0 (%)

0.0

-10.0 Russell 2000 Value -20.0 Equity REITs -30.0

-40.0 Jul-90 Jul-91 Jul-92 Jul-93 Jul-94 Jul-95 Jul-96 Jul-97 Jul-98 Jul-99 Jul-00 Jul-01 Jul-02 Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02

Sources: Ibbotson Associates; PREI

REVIEW 27 shown a downward trend similar to that dation in the REIT market that results in observed with the S&P 500, the correla- fewer but much larger companies). tion between REITs and small cap value stocks has fluctuated within a relatively narrow band and remains quite high. INVESTOR SENTIMENT AND A direct comparison between the total MARKET ROTATIONS returns for REITs and the Russell 2000 Value index further illustrates the strength For most investors, the past two years have of this relationship. Figure 4 shows that been a painful reminder of the market’s ten- REITs and the Russell 2000 Value index dency to cycle through bull and bear mar- have moved in very close tandem since the kets. The duration and remarkable high of early 1990s. The peaks and valleys of the the most recent bull market and the swift- two indices are virtually identical. Because ness and breadth of the decline since the REITs have behaved like small cap value bubble burst demonstrate quite clearly the stocks, we expect they likely will continue potential force and severity—good and to do so in the future, barring some fun- bad—of market rotations. Figure 5 shows damental change (e.g., significant consoli- one view of the changes in investor percep-

Figure 5 Distinct Periods of Value vs. Growth

Trailing 12-Month Total Return Differential Between Value and Growth of Russell 2000 80.0

60.0

40.0 1 3 5 7 9 20.0

0.0 (%)

-20.0 2 4 6 8 10 -40.0

-60.0

-80.0

Sources: Ibbotson Associates; PREI

28 ZELL/LURIE REAL ESTATE CENTER tions of the public equities market. The fig- for the market as a whole. What is remark- ure demonstrates the difference between the able about the pattern in Figure 5, however, trailing 12-month total returns for the is the magnitude of the two most recent Russell 2000 Value and Growth indices. periods. During the most recent growth Shaded areas below the x-axis, identified by phase, from late-1998 through September the odd numbers, indicate periods during 2000, small cap value stocks under- which growth stocks outperformed value performed small cap growth stocks by an stocks. Shaded areas above the x-axis, iden- average of 25 percent on a trailing 12- tified by the even numbers, indicate periods month basis. At the peak of this growth during which value stocks outperformed phase, value stocks underperformed growth stocks. growth stocks by more than 70 percent. The cyclical pattern confirms our basic Since then, however, value stocks have intuition that the market goes through outperformed growth by an average of cycles during which the prospects for 38 percent on a trailing 12-month basis, growth are perceived as being better or and at the peak of the current cycle, out- worse for different sectors of the market or performed growth stocks by 63 percent.

Figure 6 REIT NAV Premiums/Discounts Approximate Value/Growth Phases

REIT Price Relative to NAV versus Value-Growth Sentiment Index

60

40 DiscountPremium? Premium Discount

20

0 (% )

-20 Premium

-40 REIT Price/NAV (trailing 3-mo avg) Value-Growth Sentiment -60 1Q90 3Q90 1Q91 3Q91 1Q92 3Q92 1Q93 3Q93 Sep-94 Sep-95 Sep-96 Sep-97 Sep-98 Sep-99 Sep-00 Sep-01 Mar-94 Mar-95 Mar-96 Mar-97 Mar-98 Mar-99 Mar-00 Mar-01 Mar-02

Sources: Green Street Advisors (quarterly data until 1994, then monthly); Ibbotson Associates; PREI

REVIEW 29 PREMIUM/DISCOUNT AND V ALUE/GROWTH CYCLES While the fit is obviously not perfect, considerable overlap occurs between the Because most public real estate companies periods during which growth stocks were behave like small cap value stocks, it seems in favor and REITs, on average, traded at logical that the cyclical rotation between discounts to NAV, and periods during the growth and value orientation of the which value stocks were in favor and stock market should influence the valua- REITs traded at premiums to NAV. In tion of REIT stocks. Green Street Advisors 1998 and 1999, REITs sold off sharply has tracked REIT pricing premiums and and traded at discounts to NAV despite discounts over NAV since 1990, with the robust conditions in the property quarterly frequency prior to 1994 and markets. This REIT bear market co- monthly frequency since then. Figure 6 incides with the abrupt shift in stock shows an overlay of the 3-month average market sentiment as investors rotated out premium/discount in REIT prices relative of value stocks and into growth stocks, to NAV shown in Fig. 1 and the value- mostly tech stocks. More recently, REITs growth return differentials from Figure 5. have outperformed both the broader

Figure 7 Property Market Cycles Also Influence Real Estate Stocks

Annual Income Growth of Real Estate (%) 10.0

8.0 (%) 6.0

4.0

2.0

0.0

-2.0

-4.0

-6.0

-8.0

-10.0 1990:1 1990:3 1991:1 1991:3 1992:1 1992:3 1993:1 1993:3 1994:1 1994:3 1995:1 1995:3 1996:1 1996:3 1997:1 1997:3 1998:1 1998:3 1999:1 1999:3 2000:1 2000:3 2001:1 2001:3 2002:1

Sources: Property and Portfolio Research; PREI

30 ZELL/LURIE REAL ESTATE CENTER equity markets and private real estate from 1990 through mid-1993. Income despite deteriorating property market growth spiked at more than 8 percent in fundamentals. This was largely because 1998 and again in late 2000, at the of their relative attractiveness as high height of the tech-driven market. Then yielding value stocks in an otherwise dis- came the 2001 recession, which caused mal stock market. yearly income to decline as much as 7.6 The imperfect fit of Figure 6 also percent. reveals the real estate character of REITs. Property market fundamentals help Although the forces in the public equity explain some of the imperfections in the markets appear to exert the strongest relationship between market sentiment influence on REIT pricing and perform- and REIT pricing relative to NAV shown ance, as stocks of real estate operating in Figure 6. In 1992, for example, while companies, REIT stock performance also property market conditions were is influenced by property market funda- extremely weak, REITs continued to mentals. Figure 7 shows the annual trade at a discount to NAV even as stock income growth for a hypothetical but market sentiment shifted toward value representative real estate portfolio com- stocks. Then, in late 1995 and early prised of 35 percent office, 30 percent 1996, as the real estate recovery acceler- retail, 25 percent apartment, 5 percent ated, REITs traded at a premium to NAV warehouse, and 5 percent hotel proper- even though market sentiment favored ties (to correspond to the approximate growth stocks. In fact, for a relatively distribution within the equity REIT brief period, REITs were being bought market). In this case, income is the prod- and sold as growth stocks. The strong uct of rent and occupancy in the respec- recovery in the property markets, the tive sectors, and is aggregated by the potential to roll over existing leases to fixed weights assigned to each sector. much higher rents, and the healthy capi- From an earnings perspective, two tal flows from investors who bought periods of weakness and one period of underpriced property in the private mar- general strength have occurred in the kets allowed REITs to deliver returns property markets since 1990. During the comparable to growth stocks for about growth period of the property market two years. (3Q93–1Q01) income growth averaged The effects of the property and capi- around 5.5 percent per year, versus an tal markets are not always offsetting, of average annual decline of 3 percent per course. When market sentiment shifted year in the real estate market recession back toward value in late 1996 and 1997,

REVIEW 31 REITs carried forward the momentum volatile, a significant portion consists of they had achieved during their high marginal capital that views real estate growth phase and continued to trade at stocks primarily as a sector of the equities premiums to NAV that exceeded 20 per- market. It is not surprising, therefore, that cent. In 1998, however, when market real estate stocks are strongly influenced by sentiment shifted back toward growth, stock market rotations of the large margin- REITs were no longer perceived as al capital base. growth stocks, and REITs endured two years of negative returns as growth investors rotated into other sectors. SUMMARY Clearly, value-growth rotations in the stock market have been more frequent The general findings of this study con- than changes in property market cycles. firm what many people in the industry These rotations in the broader stock mar- already accept about real estate stocks— ket strongly influence investor sentiment that they are both real estate and stocks. toward REITs, as measured by the pricing The strong relationship between REIT premium/discount relative to NAV. While performance and market sentiment property market conditions also affect toward small cap value and small cap REIT pricing and can magnify or moder- growth stocks provides valuable insights ate the effects of value-growth market rota- into the often puzzling disconnect tions, most of the equity capital in the between the public real estate market REIT market does not flow through dedi- and the private property markets. While cated REIT mutual funds and closed-end public real estate companies afford funds. With roughly $15 billion of capital investors access to the investment char- in real estate mutual funds and another acteristics of private real estate, especial- $2.5 billion in closed-end real estate funds ly high and relatively stable yields, they (raised in 2001 and 2002), dedicated real represent a very small sector of the pub- estate funds account for only a small share lic equities market. Because of the small (less than 11 percent) of the $163 billion size of the sector, capital flows in the total REIT equity market capitalization. public equities market can and often do Although some of the capital outside of easily overwhelm the private market dedicated REIT funds may be invested in property characteristics of real estate REITs and REOCs as part of a real estate stocks when these characteristics are strategy, which in theory should make cap- either in or out of favor. As shown in ital flows into and out of the sector less this report, REITs have traded at premi-

32 ZELL/LURIE REAL ESTATE CENTER ums to NAV when value investing is in favor, and at discounts to NAV when growth investing is in favor. Since senti- ments in the stock market change much faster and less predictably than property market cycles, the stock market gyration dominantly delineates the cycles of REITs trading at premiums or discounts to NAVs. Investors, therefore, must be aware not only of property market fundamen- tals when investing in real estate stocks, but also of changes in market sentiment that might influence the valuation of REITs and REOCs. While this added dimension can be a source of risk for investors who choose to gain exposure to the asset class through the public equities market, the emergence of meaningful public real estate capital markets has overwhelmingly been a source of opportunity for real estate investors. With an understanding of the public market’s influence on real estate stocks, sophisticated real estate investors can take advantage of the industry’s dual capital markets (public and private) to exploit arbitrage opportunities that arise when the public or private markets price real estate assets differently.

REVIEW 33