Dow Jones Property: Parting Shot

Do Earnings Drive Stocks?
Despite solid growth in cash flows and the strong underlying fundamentals of the commercial property markets, REITs continue to trail the Standard & Poor's 500-Stock Index by a wide margin this year.

by David J. Kostin

Earnings and cash flow growth are among the key variables responsible for higher stock prices. The analogue for real estate investment trusts is that higher per-share funds from operations should translate into higher share prices. Unfortunately, while this growth-price relationship appears to hold true for the broader domestic equity market, solid increases in first quarter 1998 REIT FFO per share have been largely ignored by the stock market.

Although 88 equity REITs (of the 150 companies in our statistical universe) had reported first quarter results by May 1, with an average year/year growth of 13.6% above the comparable year-ago level, share prices for most REITs have declined year-to-date. Furthermore, positive surprises outnumbered negative surprises by a 2.8:1 ratio. Of the 88 companies reporting, 37 posted results above our or First Call consensus expectations, 38 were in-line with our or consensus forecasts, and only 13 represented negative surprises.

Despite solid growth in cash flows and the strong underlying fundamentals of the commercial property markets—generally falling vacancy rates and rising rental rates—REITs have dramatically trailed the S&P 500 (15.5% vs. a negative 3.1% for the Morgan Stanley REIT Index, as of May 1) since the start of 1998.

Chart One mathematical implication of both stronger-than- expected earnings results and flat or declining share prices has been a substantial compression in the average price/FFO multiple for the industry. At the end of 1997, REITs traded at an average of 13.1 times forward four-quarter FFO per share calculated on a capitalization weighted basis (see graph). Most recently, that average had declin-ed by approximately 11.5% to an average of 11.6x.

This multiple compression is surprising given the generally robust outlook for most companies in the industry. In fact, on a quarterly basis, year/year FFO growth for the REIT industry is expected to accelerate during the balance of 1998. In the rest of the stock market, where earnings growth drives stock prices, such an accelerating earnings situation would typically be accompanied by a rising (not falling) multiple.

The only explanation for the weak performance of the sector year-to-date appears to be in the irrational exuberance of many REIT executives to issue new primary common shares into the market. The unceasing pace of REIT equity issuance has served to dampen the enthusiasm of some portfolio managers to invest in the sector. If such disaffection persists, it would be unfortunate because the sector relies on access to capital and attractive returns are still available, particularly for those companies focusing on development. The competition for existing assets is extremely competitive, and acquisition yields have contracted dramatically—almost as much as the price/FFO multiples.

David Kostin follows REITs and other property-linked stocks at Goldman, Sachs & Co. in New York. He can be reached at david.kostin@gs.com.