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Ever since the Great Recession of 2008, the Federal Reserve has kept interest rates at rock-bottom levels in an attempt to reignite economic growth.
A casualty of this policy is any investor who desires income from their investments, such as retirees, who are being paid little to no interest on traditional income-producing products like bank certificates of deposit. Even the 10-year Treasury bond yields just 1.75% right now.
Investors are starved for yield. As a result, many have plowed into dividend stocks. One of the most popular asset classes for income generation are real estate investment trusts, or REITs. These stocks have soared over the past several years, thanks in large part to their hefty dividends.
But investors looking at REIT stocks right now should know that many, including Realty Income (NYSE: O), CubeSmart (NYSE: CUBE), and Digital Realty Trust (NYSE: DLR) seem overvalued.
Valuing REIT Stocks Through the Proper Lens
Rather than focus on GAAP earnings per share, the traditional metric used by analysts to value stocks, investors should steer their research toward a different figure when evaluating REITs.
Instead, REITs usually report their results in terms of funds from operation, or FFO, which is a non-GAAP equivalent measure to EPS. Focusing on FFO provides a more accurate picture of a REIT’s fundamentals.
For example, last year, Realty Income grew revenue by 9.6% to $1.023 billion. Its FFO per share in 2015 increased 7.4% to $2.77, as compared to $2.58 the previous year.
CubeSmart’s business model is the ownership, operation, acquisition and development of self-storage facilities. It grew funds from operation by 15% last year.
For its part, Digital Realty grew core FFO by 6% last year, and expects another 5% increase in 2016. These are good enough results, but it’s hard to justify Digital Realty’s 41% rally over the past year based on mid-single-digit growth.
The problem is that investors do not appear to be pricing in much risk. These REITs are sitting near multi-year highs. Their valuation multiples have expanded significantly because of this, perhaps due to investors’ thirst for yield in this low-rate environment.
CubeSmart stock currently trades for 26 times trailing FFO. Realty Income trades for 22 times 2015 FFO, while Digital Realty trades for 18 2015 FFO. Digital Realty’s multiple is slightly below the S&P 500 earnings multiple, but CubeSmart and Realty Income are valued well above the market. Consider that just a few years ago, these REITs’ multiples were in the low-double digits.
A separate consequence of this is that their dividend yields are at five-year lows. CubeSmart is the lowest yielding stock of the three. It yields just 2.6%, which is barely above the S&P 500 average yield, and is not indicative of historical REIT yields.
It should be noted that REITs are not without risk. Aside from valuation risk, the biggest risk investors need to keep in mind is interest rate risk. This widely affects REITs because they operate highly debt-heavy capital structures. When rates go up, interest expense goes up. This threatens to raise REITs’ cost of capital, which would negatively impact future growth.
Great Companies, But Not Great Stocks
To be sure, these are good companies. The REITs mentioned all have capable management teams, strong business models and reliable dividends.
For example, Realty Income is one of the most popular dividend stocks in the entire market. It calls itself “The Monthly Dividend Company” because it pays its dividend each month, and it has raised its dividend regularly for a very long time.
Realty Income has made 549 consecutive monthly dividend payments, and has raised its monthly dividend 85 times since its initial public offering in 2004. Similarly, Digital Realty recently raised its dividend by 3.5%, marking the 11th consecutive year of dividend hikes.
But their dividend yields are at multi-year lows, and their valuations are at multi-year highs. It’s been a great ride for investors who have owned these stocks for any length of time, but it spells trouble for investors buying them today.
Considering the potential headwind coming in the form of higher interest rates, investors would be wise to hold off for a better buying opportunity.
DISCLOSURE: Bob Ciura personally owns shares of Digital Realty Trust (NYSE: DLR).
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