The most common way of calculating the relative value of a REIT such as Simon Property Group (SPG) is the price-to-FFO (funds from operations) multiple. FFO is widely used because it is the main earnings metric for REITs. It is similar to EPS (earnings per share) in other industries. The price-to-FFO multiple is equivalent to the PE (price-to-earnings) ratio used in other industries.
Decline in multiple
In its peer group, apartment REITs are trading at the highest price-to-FFO multiple of 16.84x as of August 2015. Apartment REITs are followed by industrial REITs with a price-to-FFO multiple of 16.5x, while office REITs trade at 14.8x. The price-to-FFO multiple for shopping center REITs is 13.8x, while health care REITs have a multiple of 11.6x. In fact, all sectors of REITs have witnessed a decline in 2015 compared to fiscal 2014. REITs are now trading at a 15.2x price-to-FFO multiple, which is below its long-term average of 17.2x, even though the earnings have remained solid.
The decline in price-to-FFO multiple for most of the REITs in 2015 and especially in the June to August period can be attributed to an expected hike in interest rates in the near future. Investors who buy REITs for their high dividends during the period of low bond yields often sell them as bond yields start to rise. In addition, higher interest rates raise the cost of capital for REITs, which affects their bottom line.
However, this may not necessarily always be true. This is because as long as higher interest rates are driven by economic growth and job growth, it should support demand for commercial real estate. This leads to higher valuation for fundamentally strong REITs such as Simon Property Group (SPG), General Growth Properties (GGP), Boston Properties (BXP), Equity Residential (EQR), and the iShares Cohen & Steers REIT ETF (ICF).
In the next part of the series, we’ll discuss the outlook for the REIT industry.