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PB: EQUITY REITS: WHY REITS ARE EXPENSIVE ON A DIVIDEND YIELD SPREAD BASIS 02:12pm EDT 15-Jul-03 Prudential Equity Group, Inc. (J.SULLIVAN) C EQUITY REITS: WHY REITS ARE EXPENSIVE ON A DIVIDEND YIELD SPREAD BASIS PRUDENTIAL EQUITY GROUP July 15, 2003 REITs ----- ANALYST(S) -------------------- -------- OPINION ------- James W. Sullivan Current: Market Underperform William Acheson Robert Belzer 1 James C. Feldman Phillip A. Juhan, Patrick Walsh, Wadi M Gonzalez All important disclosures can be found at the end of this report. ----- HIGHLIGHTS ------------------------------------------------------------ * When we downgraded Equity REITs to Underperform on June 13, we noted that REITs appeared expensive to us by almost every measure. * One of the more important metrics is the relative yield between REITs and the broader equity market. * The historic yield spread between Equity REITs and the S&P 500 should be adjusted to reflect the different tax treatment between REITs and non-REITs. * When adjusted accordingly, REITs are relatively expensive currently to the broader market on a dividend yield basis. * Moreover, we suspect that non-REITs are likely to grow dividends at a much higher rate than REITs over the next year, given the recent tax legislation and initial indications of response by several non-REITs. ----- DISCUSSION ------------------------------------------------------------ We Have Tracked The Spread Between The Yields For Equity REITs And The S&P 500 For Some Time. Although the REIT universe has changed materially since 1972, we have tracked the yield differential between the NAREIT Index and the S&P 500 since 1972 as one indication of comparative REIT valuation. Over that time, the REIT industry has become a much bigger, better capitalized universe and, in fact, a handful of REITs are now in the S&P 500. But what has not changed is that one of the primary reasons that investors buy REITs is that the sector offers a higher-yielding, lower-beta diversification to the broader equity market. Those characteristics are of course even more important during a period when the broader market (and the debt market) offers a relatively low income return. Over The Last 31 Years, The Spread Has Averaged 4.4%. Over the last 31 years, the spread between the average Equity REIT yield and that of the S&P 500 has been 440 basis points. The difference between the highest (935 bps) and the lowest (97 bps) spread has been wide. But both of those extremes occurred in the 1970s when the REIT structure was relatively new, and balance sheets were poorly managed. If we include the 1970s, there appear to have been three fairly distinct cycles for dividend spread trends. The first cycle began with the data series in January 1972 when the spread was 3.13%. The peak in the spread occurred in April 1974, a little over two years later when the spread reached 9.35%. From that point, spreads narrowed sharply and finally bottomed in August of 1979 when the spread was 0.97%, the only month over the 31-year period when the spread was below 1.00%. The second cycle began with that August 1979 low. From that point, the spread expanded sharply over the following year before settling into a fairly remarkable 4 1/2-year period when the spread stayed in a 100 bps range from a low of 2.40% to a high of 3.43%. The spread then jumped sharply to 3.92% in January of 1985 and proceeded to rise consistently over the next six years to a cyclical peak of 7.11% in October of 1990. From that October peak, the spread then contracted sharply to a range of between 300 bps and 500 bps over the next seven years. From the beginning of 1998, over the next two years, the spread moved to its third distinct peak of 7.56% as the growth style of investing was in favor and defensive stocks and especially dividends were out of favor. With the collapse of NASDAQ from the start of 2000, we are now in the fourth year of an extended period in which the value style of investing has been ascendant, and dividends appreciated by investors once again. The spread has narrowed by approximately 300 bps from 7.56% to 4.60%. As of the end of June, the spread was 4.72%, close to the 4.40% average spread over the last 31 years. Many of those that argue that the favorable tax treatment accorded to non-REIT dividends should not be a negative for REITs usually cite the fact that REIT dividend yields remain well above those for non-REITs. But that has always been the case. Only a perpetual REIT bull would stop the analysis at that point. On A Tax-Effective Basis, The Spread Is Now Well Below That Historic Average... Under the recently passed tax reduction measure, dividends paid by non-REITs generally will be taxed at a 15% marginal tax rate. REIT dividends do not qualify for the tax relief, although a small portion may to the extent that the dividends can be attributed to income that has been taxed at the corporate level. But for those REIT shareholders that are reasonably affluent, their REIT dividends are subject to tax rates of 35%. For these income-orientated investors, the after tax cash flow is what counts. (Note that we do not factor in the potential return of capital component in REIT dividends or the potential for capital gain distributions because such factors existed both before and after the recent tax legislation.) We assume that these taxpayers will over time apply the same tax-effective math that has been applied to the comparative yields between taxable fixed income and municipal bonds to assess the attractiveness of REIT yields. If we apply the differential tax rates to REIT dividends and the S&P 500 as of the end of June without making any adjustment for the small number of REITs in the S&P 500, the effective spread declines from 472 bps to 272 bps. It is interesting to note that that resulting 272 bps spread is at the lower end of the very tight 100 bps range that prevailed in the first half of the 1980s that we outlined above. Figure 1. Yield Spread On A Tax-Effected Basis S&P 500 NAREIT EQUITY Spread Index Value 100 100 Yield 1.70% 6.42% Dividend $1.70 $6.42 472 bps Tax Rate 15% 35% Net Div'd $1.45 $4.17 272 bps Source: Prudential Equity Group, Inc., NAREIT, Standard & Poors. Effective pre-tax yield as of 6/30/03. .And Makes REITs Appear Very Expensive. Since 1972, there have been only 30 months out of 366 consecutive months that the spread between REIT dividends and those of the S&P 500 were less than 272 bps. Moreover, the last month in which that was the case was December of 1984. In general, the tight spreads occurred during periods of high inflation and high long term interest rates when REIT investors were attracted by the notion that real estate served as a good inflation hedge. Indeed, during that period, REIT dividend yields were well below those offered on long-term treasuries. Moreover, The Stars Appear Aligned For Substantial Dividend Increases By Non-REITs. A rational response by non-REITs to the lower tax rates on dividends would be to increase dividends at a higher than average rate. This would also be consistent with the emerging shift in management incentive compensation to restricted stock from stock options. There have been examples of this change in sentiment recently. Citicorp (C, $47.12--rated Hold by Prudential Equity Group Senior Banks/Large Cap Analyst, Michael L. Mayo) increased its dividend by a dramatic 75% on July 14. There have been indications that Microsoft (MSFT, $27.40-- not rated) is likely to start paying dividends. All indications are that more non-REITs are planning to initiate dividends that have not done so previously and that those companies that pay dividends are likely to increase the dividends at a higher rate. Moreover, per-share earnings for the companies in the S&P 500 are projected to grow at a double-digit rate for 2003 and, thus, those companies have the means as well as the motive to increase dividend payouts. In short, the widespread expectation is for above-average dividend growth among non-REITs. .And Reduced Dividend Growth For REITs. In contrast, REIT dividend growth has been declining. Over the last 12 months, the average Equity REIT dividend increased by 1.3%. Growth in FFO per share was negative last year and expected to be negative this year before increasing to an estimated mid-3% level for 2004. And for several REITs, payout ratios remain uncomfortably high and can only be sustained if per share cash flow grows materially - an unlikely prospect. There will be notable exceptions: REITs that feature strong growth in cash flow as well as very low payout ratios are likely to announce very sizable dividend increases this year. But they are likely to be the exception. Since 1997 when annual REIT dividend growth was 7.9%, dividend growth for REITs has steadily declined and was negative in 2002. In the first six months of 2003, it was 0.1%. (See Figure 2.) And several companies have unhealthy payout ratios when measured as a percentage of funds available for distribution (FAD) especially if asset sales gains are deducted from reported FAD. Figure 2. Annual Dividend Growth For REITs Year Annual Div'd Change 1997 7.9% 1998 5.4% 1999 5.4% 2000 5.6% 2001 4.0% 2002 (0.9%) Jun-03 0.1% Source: Company reports. As Far As We Are Concerned, The Writing Is On The Wall. Investors that are hungry for yield are understandably drawn to REITs, and some are less sensitive to the after-tax spread because of their marginal rates or because the ownership entity does not pay tax. But we do not think it prudent to ignore the impact of the tax legislation, especially when comparing relative yield spreads. Moreover, forward-looking investors should take into account that we are likely entering a period when dividend growth should be accelerating for non-REITs and contracting for REITs. As far as we are concerned, the evidence is clear: REITs are expensive on a relative yield basis. ----- DISCLOSURES ----------------------------------------------------------- The research analyst, a member of the team, or a member of the research analyst's household does not have a financial interest in any of the stocks mentioned in this report . Prudential Equity Group has no knowledge of any material conflict of interest involving the companies mentioned in this report and our firm. Prudential Equity Group, Inc. makes a market in the shares of MSFT. Prudential Equity Group, Inc. and/or its affiliates have managed or comanaged a public offering of securities in the past 12 months, have received compensation for investment banking services in the past 12 months, or expect to receive or intend to seek compensation for investment banking services in the next 3 months from C. The research analyst or a member of the team does not have an actual material conflict of interest relative to any of the stocks mentioned in this report . The research analyst has not received compensation that is based upon (among other factors) the firm's investment banking revenues as it relates to any of the stocks mentioned in this report . --------------------------------------------------------------------------- When we assign a Buy rating, we mean that we believe that a stock of average or below average risk offers the potential for total return of 15% or more over the next 12 to 18 months. For higher risk stocks, we may require a higher potential return to assign a Buy rating. When we reiterate a Buy rating, we are stating our belief that our price target is achievable over the next 12 to 18 months. When we assign a Sell rating, we mean that we believe that a stock of average or above average risk has the potential to decline 15% or more over the next 12 to 18 months. For lower risk stocks, a lower potential decline may be sufficient to warrant a Sell rating. When we reiterate a Sell rating, we are stating our belief that our price target is achievable over the next 12 to 18 months.A Hold rating signifies our belief that a stock does not present sufficient upside or downside potential to warrant a Buy or Sell rating, either because we view the stock as fairly valued or because we believe that there is too much uncertainty with regard to key variables for us to rate the stock a Buy or Sell. Rating Distribution 07/14/03 Firm's Sector's Firm IBG Clients Sector IBG Clients Buy 40% 4% 21% 1% Hold 56% 5% 75% 3% Sell 3% 0% 4% 0% 06/30/03 Firm's Sector's Firm IBG Clients Sector IBG Clients Buy 40% 4% 21% 1% Hold 57% 5% 75% 3% Sell 4% 0% 5% 0% 03/31/03 Firm's Sector's Firm IBG Clients Sector IBG Clients Buy 39% 3% 25% 1% Hold 57% 6% 71% 3% Sell 3% 0% 5% 0% 12/31/02 Firm's Sector's Firm IBG Clients Sector IBG Clients Buy 38% 3% 27% 1% Hold 59% 5% 68% 3% Sell 3% 1% 5% 0% Excludes Closed End Funds



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