Morningstar Advisor - October/November 2010 - 27

Exhibit 1 Real Estate Fund Flows Follow Returns
$ million

2000

Flows Into Real Estate Funds (in Millions)

Category Performance

% Return

and need replacing. But REITs uniformly report FFO, so we’ll consider it with the understanding that it can provide a rosier cash-flow and valuation picture than what 1800 really exists. If we divide the price of a REIT by its FFO, we 1400 get a good idea about how the REIT is being valued by the market. We looked at the 1000 15 top holdings of four popular real estate mutual funds: Cohen & Steers Realty Shares 600 CSRSX, Fidelity Real Estate Investment FRESX, T. Rowe Price Real Estate TRREX, and Vanguard REIT Index VGSIX. The holdings were trading 200 at an average price/FFO multiple of about 19 based on the stocks’ closing prices on Aug,0 0 18 Exhibit 2. REITs are stocks or ownership 40 units of businesses. In the stock market, paying 19 times operating cash flow (which is similar to price/FFO) has rarely produced a good long-term result for companies that don’t grow very much. Of the top 15 holdings in each fund that had positive FFO for the past 12 months, only two—retail landlord Kimco KIM and New York City office owner SL Green SLG—clocked in with price/FFO below 15. Some firms have posted negative FFO for the past 12 months because of noncash write-downs or impairments of land held for development or developments partly finished, and we left them out of our calculation. Those impairments could be reversed in the future, but they also can get worse. If we flip the price/FFO of the top 15 holdings around, owners of these stocks are getting a 5.3% FFO yield, about half of what REIT investors were getting 10 years ago. REITs would have to grow considerably to bump FFO yields back to 10%. REITs are inherently constrained from significant growth because of the legal constraint requiring that they pay a large amount of earnings as dividends. As a comparison, Apple AAPL, which is expected to increase sales and earnings more than any REIT in the coming years, is currently trading at around 19 times trailing earnings.

1600

1200

800

400

2009

2010 (through July 31)

Exhibit 2 A Look at What Funds Are Holding
Fund Current Yield % Price/FFO of Top 15 Holdings Avg. Star Rating of Top 15 Holdings % Assets in Top 15 Holdings

Cohen & Steers Realty Shares CSRSX Fidelity Real Estate FRESX T. Rowe Price Real Estate TRREX Vanguard REIT Index VGSIX
Average of Four Funds
Data as of Aug. 18, 2010

2.32 2.17 n/a 2.45
2.31

19.5 18.4 18.7 19.8
19.1

2.8 2.8 2.6 2.45
2.7

53.5 67.4 61 53.5
58.8

interest from 10-year U.S. Treasuries, and we studied the future five-year returns of REITs based on the dividend yield at the time of purchase. Third, we examined how Morningstar’s equity analysts currently view REITs. Finally, we analyzed how much exposure three go-anywhere mutual fund managers have had to REITs over the past decade or so. We think that go-anywhere managers provide a more objective view of the asset class than dedicated REIT fund managers, who have to own REITs regardless of their underlying valuations.
Analyzing FFO

get the FFO number, analysts must adjust a REIT’s net income for property sales and depreciation, which is a material noncash charge (the IRS allows real estate companies to depreciate property at a prodigious rate that distorts the reality of a property’s cash-flow generation). This, by the way, is why a traditional price/earnings metric is an ineffective REIT valuation tool. REITs actually generate more cash than their net income lines indicate. To be sure, using the FFO as a valuation tool has its shortcomings. It adds back the full depreciation charge even though, as any homeowner knows, a property requires significant upkeep; appliances, plumbing, wiring, and countless other things wear out

Funds from operations is a REIT metric that analysts use to see how much cash flow a group of properties or a REIT is generating. To

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Morningstar Advisor - October/November 2010

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