Description

I recommend shorting the iShares Dow Jones U.S. Real Estate Index Fund (AMEX: IYR; inception date 6/12/2000) as I believe the shares, at current prices, present an asymmetric risk/reward. The IYR, which is managed by the index strategies group of Barclay’s global and is exempt from the uptick rule, is an exchange traded Fund whose investment objective is to mirror the price and yield performance, before fees and expenses, of the Dow Jones U.S. Real Estate Index. The IYR, which is float adjusted and market-cap weighted, is reasonably diversified and is comprised of 81 REIT securities. The top 10 holdings – listed below -- make up approximately 34% of the value.

The IYR has been a great defensive investment as exhibited by its performance over the last several years. Its total return for the past four years, and the corresponding return for the S&P500, is listed below. Shares have benefited from the rally in bonds and have been buoyed by $6.6 billion of real estate mutual fund inflows (on top of $4.5 billion of inflows in 2003 and $3.4 billion in 2002) as retail investors have continued to bid up yield-oriented investments. The sector’s total assets managed in open-end mutual funds is $43.9 billion, so assets in such funds have increased 17.9% this year. Notably, the large-cap REITs have outperformed the small-cap REITs by 1000 basis points, supporting the observation that fund flows are important drivers of performance.

IYR S&P500
2001 11.2% -11.9%
2002 1.6% -22.1%
2003 34.4% 28.7%
2004YTD 28.9% 10.9%

The total return of the IYR over this almost four year holding period has been 98.9% compared to -2.2% for the S&P500. Much of the recent out-performance has been driven by significant multiple expansion; operating fundamentals have been mixed depending on the sub-sector of the REIT market.

The investment thesis is there is an asymmetric risk/reward in shorting the IYR: If interest rates stay moderate, you are unlikely to lose much capital. Estimated 2005 FFO growth rates are low single digits and cap rates (the inverse of earnings multiples…and how private market values in real estate are established) are unlikely to move much lower. If rates rise, however, the shares are likely to under-perform significantly. REITs do go through boom and bust cycles: in 1998-99 the sector fell 21% including dividends as spreads widened and equity issuance increased significantly. YTD issuance through November is $14 billion, the highest since 1998 (although well below 1997’s levels).

The REIT market today is expensive based on (1) dividend yield spread versus 10-year treasuries; (2) absolute and relative Price/Adjusted FFO multiples; and (3) relative to private market values (Price/Net Asset Value)

1. The overall REIT market is currently trading at a 62 basis point premium to the risk-free ten year US treasury note, versus a long term average (1993-2004) of 120 basis points. The dividend yield for the IYR is actually trading at a discount to the ten year; it yields 4.24% (not a terrible short-selling carry) which compares to the current yield of 4.28% on the risk-free ten-year US Treasury note. In April/May of 2004, the ten year’s yield surged from 3.88% to 4.79% leading to a sharp and sudden 19% fall in IYR’s price (from 110.71 on 4/1/04 to 89.85 on 5/10/04). While the historical R2 against the 10-year treasury note is only 55.2% (it is a much tighter 98.6% against the S&P500 REIT index), clearly a unexpected upward move in rates could be painful for those long IYR.
2. The REIT sector is also expensive relative to the broader equity market: the P/AFFO multiple of the REIT sector is 14% above the P/E multiple of the S&P500, versus its long-term historical average of a 33% discount to such index. REITs historically have never traded at a higher multiple than the S&P500. Dividend payout ratios as a percentage of 2005 adjusted FFO are quite high in certain sectors (apartment REITs on average are paying out 102% and office REITs are paying out 95% of AFFO) anticipating a cyclical recovery.
2. Finally, REIT’s are trading historically rich as a multiple of NAV. The average REIT is currently trading for 18.8x Adjusted FFO (a proxy for cash flow) versus a longer term average of 11.6x. The confluence of retail fund flows as well as institutional and foreign investors allocating increasing amounts of capital to real estate, despite mixed fundamentals, has driven up valuations. Analysts have followed suit in marking up NAV’s. For example, Merrill Lynch recently indicated NAV’s (based on Q3 results and new capitalization rate assumptions) rose by 31.6% on a year-over-year basis. Valuation increases driven by multiple expansion of such magnitude are not sustainable; future growth will have to come from operating income growth, accretive acquisitions or development. So if this growth occurs, the economy will have strengthened and rates will likely rise. And if growth does not materialize, valuations would appear to be somewhat capped. Notably, estimated FFO growth for 2005 is 4%.



Random Notes:
1. There are other real estate ETFs including the ICF, RWR and VNQ. I have picked the IWR as it is the most liquid.
2. In general most ordinary dividends paid by REIT’s are not eligible for the reduced 15% tax rate on dividends brought about by the 2003 Tax Act because REITs receive a dividends paid deduction enabling them to avoid corporate level tax
3. Top ten holdings
1. Simon Property Group (SPG) 5.6%
2. Equity Office Properties (EOP) 4.7%
3. Equity Residential (EQR) 4.0%
4. Vornado Realty Trust 3.5%
5. General Growth 3.1%
6. Prologis 3.0%
7. Archstone-Smith 2.9%
8. Plum Creek Timber 2.8%
9. Boston Properties 2.7%
10. Kimco 2.1%

Catalyst

Increasing interest rates; widening spreads; reversal of strong fund flows; increased supply thru new equity issuance