Why Not All REITs are the Best Investments for Yield

In a yield-starved world investors have turned to real estate investment trusts (REITs) as some of the best investments for income.

REITs are structured so that they have to pay out the majority of their income to shareholders in order to retain their favorable tax status. Most of them yield far more than Treasury or corporate bonds so they have attracted attention and dollars over the past few years.

It is not just individual investors who are searching for yield. Large pension and investment funds can no longer meet their required rates of return by investing in traditional fixed income investment. They too have turned to REITs to make up the income shortfall.

However, when these large investors begin to direct billions of dollars towards the sector they are not very selective. Much of the money that flows into REIT funds and exchange-traded instruments is only concerned with gaining exposure to the real estate markets and gaining a yield advantage. This type of buying has helped the price of many of the larger more liquid REITs double and even triple over the past few years. They now trade at substantial premiums to their underlying asset value and earnings power.

The problem facing investors now is that the dollars have flowed into the securities for several years now and pushed prices to what may be unsustainable levels.

Any real estate investor can tell you that buying commercial or residential property in excess of its real value is a recipe for disaster especially if you use leverage.

A recent article in The Wall Street Journal's "Heard on the Street" column shows there is another developing threat to REIT prices. 

According to the article, Japanese investors have been piling into U.S. REITs to take advantage of the extreme yield differentials as that country is using low rates to attempt to stimulate the economy.

In addition to the dividends, however, the Japanese funds are also paying out appreciation, including unrealized gains. If the growth in REIT share prices begins to moderate, these funds will have to start selling shares to maintain their payouts and this could pressure prices as they own billions of U.S. REIT securities.

Not All REITs are the Best Investments for Yield

To gain an idea of how overvalued some of the securities have become let's take a look at the largest U.S. REITs.

Simon Property Group Inc. (NYSE: SPG) is the largest REIT owning retail shopping centers and malls. In the past three years, the shares have more than doubled as money in search of yield flowed into real estate related investments.

As the economy and real estate markets have improved so have results for the company.

Rents and occupancy rates have been rising as consumers and businesses have returned to malls. As pleasant as that sounds, the problem comes from the fact that investors have noticed the solid results and decent yields and pushed the shares to unsustainable levels.

The stock currently has a market capitalization of $55 billion and more than $22 billion of debt for a total enterprise value of about $78 billion. That is two-and-a-half times the total assets owned by the company - and extraordinarily high level.

The shares fetch more than 50 times earnings and 20 times the expected funds from operations the company hopes to earn in 2013.

More troubling from an investor's point of view is the fact that institutions own more than 95% of the shares. Over 8% of the company is owned by those potentially pesky Japanese REIT funds.

When REITs eventually fall out of favor, the exit door will be very crowded and the price decline is likely to make the 2.56% yield seem even more paltry than it is in reality.

This is not to imply that Simon is a bad company or does not own a portfolio of premier malls. The company did not get to be the largest REIT because of bad management or poor properties.

The problem is the price. Yield-seeking money flows have pushed the price far higher than the actual value the company and the properties.

The same is true of many of the other large-cap REITs and investor should exercise caution until prices return to more reasonable levels.

For a more detailed look at why not all REITs are the best investments for yield, check out the REIT names that Money Morning Global Investing Strategist Martin Hutchinson called "the most dangerous."