NEW YORK (Reuters) - Sears Holding Corp made a huge splash last week when it said it might spin off hundreds of its stores as a real estate investment trust. But the struggling retailer's move to tap into a surging commercial property market comes as the sector looks increasingly rich.
The temptation is understandable. REITs, those formed around retail properties in particular, have been one of the post-financial crisis stars. The reason: juicy dividends. And, of course, six years of low-interest rate policy from the U.S. Federal Reserve, which have pushed bond yields to historic lows.
The S&P 1500 Retail REIT industry group, which includes the likes of mall and shopping plaza owners Simon Property Group Inc., Macerich Co. and National Retail Properties Inc., delivered a total return of nearly 500 percent since March 2009. That's more than double the return of the wider stock market.
This year alone, the benchmark MSCI U.S. REIT index has surged 26 percent compared with 10 percent for the S&P 500.
Yet, just as Sears Chairman Eddie Lampert considers diving into this game, fund managers and analysts in the sector worry that the best days for publicly traded REITs are now behind them because they are too expensive.
"We're turning over rocks for opportunities, but it's clear that REITs are not cheap," said Joel Beam, manager of the Forward Income Opportunity fund.
Beam is not alone. The average equity income fund now holds 7.8 percent of its portfolio in REITs, according to Lipper, the same percentage as in 2009.
A top risk for the group is the Fed, which is widely expected to start raising interest rates next year for the first time since the recession.
Investors have been drawn into REITs by dividend yields that now average 3.5 percent, more than a full percentage point above the yield on safer assets such as the benchmark 10-year U.S. Treasury note and roughly a half-point higher than the yield on investment grade corporate bonds.
As such, shares of REITs are highly sensitive to any hint that interest rates could rise, a prospect that would make bonds more attractive by comparison.
In 2013, for instance, the S&P 1500 Retail REIT industry group fell 21 percent during the three months of the so-called "Taper Tantrum," which erupted following hints by the Fed that it would end its bond-buying stimulus program - and pivot toward a tighter monetary policy.
REITs have since recovered to record highs. But analysts say that rich valuations, at a time when the expanding U.S. economy should send interest rates higher, mean that another significant drop could be in the making.
The group is also substantially more levered than most other stocks. The average long-term debt-to-equity multiple among the 22 members of the S&P retail REIT industry group is 143.2 compared with just 94.7 for the S&P 500 as a whole.
Higher interest rates mean higher borrowing costs for new or refinanced debt, a factor that will further impede profit growth.
To be sure, some analysts say that certain REITs could do well, even in a rising interest rate environment - largely because they could pass on costs to their tenants in the form of rising rents.
A lack of new supply in the REIT market, as well as concerns that the European Union economy is in recession, should keep a floor on any price declines if rates were to rise, said Alexander Goldfarb, a senior REIT analyst at Sandler O'Neill.
But even Goldfarb sees valuations stretched for several of the companies he covers.
Added Todd Lukasik, a Morningstar analyst: "REITs look to be on average about 10 percent over-valued...what we’ve seen recently is that on days when you have a big movement upward in the yield of the 10 year Treasury, you get a pretty noticeable decline in REIT stock prices."
Income fund managers, too, say that they are put off by high valuations in the sector.
REITs now trade at an average of 23 times cash flow, Beam, the Forward fund manager said, compared with their historical average of 16 times. Should interest rates rise, he added, it will be "a little bit scary."
Reporting by David Randall. Editors: Hank Gilman and Daniel Burns.