The MSCI U.S. REIT Index finished 2012 with an 18% gain- marking the fourth straight year of outperformance relative to the S&P 500 Index.  Did you also know that this industry has outperformed in 10 of the last 12 years?  The favorable appeal of investing in real assets with consistent dividends has fueled strong demand for REIT equities.  Will outperformance continue in 2013?  Or will the excessive valuations prove to be too great of a headwind?  This article will highlight some bullish as well as bearish scenarios that investors in REITs should consider as the year unfolds.

The Bullish Case

REITs have outperformed during the past four years thanks in part to deflationary conditions that have further enhanced the appeal of investing in hard assets that pay out a steady stream of dividends.  The current yield on the overall REIT sector is 3.5% and has compressed significantly since the cyclical bull market began back in early 2009.  Still, with year-over-year inflation running at 1.7% and the 10-year Treasury yielding just 1.8% the 3.5% dividend remains attractive.  The economic landscape remains conducive to continued REIT outperformance.

REITs continue to have access to capital markets.  This means investors are comfortable with the leverage as companies seek out attractive acquisitions thanks to low financing costs.  Higher cost secured debt is being replaced with lower cost unsecured debt.  Unsecured debt has increased 38% since 3Q10 for apartment REITs with the average interest rate differential between secured and unsecured debt now around 90 basis points.  This leads to higher cash flow and higher net asset values.

But Valuation is Excessive?

The main headwind for REITs as the year unfolds is the stretched valuation.  According to Key Bank Capital Markets, the adjusted funds from operation (AFFO) multiple for the entire REIT sector sits at a 21% premium to its historical average and just 13% below the peak seen in 2007. REITs underperformed the S&P 500 by 22% in 2007!  Valuation is a key tool to long-term performance and this likely indicates that sustained outperformance in coming years will be very difficult.   Still, valuation can move to very excessive levels before mean reverting.  One key investing tip regarding mean reversion is to wait until an asset class hits an extreme valuation AND makes a clear reversal.  To this point there has been no indication of a reversal in REIT valuations.  Maybe because rather than looking at absolute valuations, it is best to look at relative valuations.

The average REIT cap rate, which is net operating income divided by the value of the property, has been compressing as asset values continue to rise- hence the stretched absolute valuation ratios referenced above.  But relative to corporate bonds and Treasuries, which have also seen surging prices, REITs remain attractively positioned.  The current spread between REIT cap rates and both corporate bonds and Treasuries is greater than the 15-year average.  Thus, REITs remain attractive relative to these two asset classes.  This should sustain the demand from risk-averse investors that have a desire for current income.

Apartment REITs Face Headwinds

Equity Residential (NYSE:EQR) and AvalonBay Communities, Inc. (NYSE:AVB) are the two bellwether apartment REITs and both are members of the S&P 500.  Below is the Price/AFFO of both companies and one can see the current ratio is clearly elevated.

The current economics on apartment REITs is a mixed bag.  Rents continue to rise and vacancies continue to fall.  In fact, the apartment vacancy rate recently fell to 4.5% and is the lowest it has been since 2001.  The two big headwinds are the affordability of houses and the vast amount of supply coming to market in the next several years.