Real estate investment trusts and related exchange traded funds have experienced another strong year as investors sought out high-yield-generating options. However, space may starting to look pricey.
“U.S. REITs appear somewhat overvalued as a group,” writes Todd Lukasik, senior analyst covering real estate, for Morningstar.
For instance, the Vanguard REIT ETF (NYSEArca: VNQ) shows a 36.1 price-to-earnings ratio and a 2.28 price-to-book and iShares Dow Jones US Real Estate Index Fund (NYSEArca: IYR) has a 33.9 P/E ratio and a 2.3 P/B ratio. In comparison, the S&P 500 index has a 17.5 P/E and a 2.4 P/B.
So far this year, REITs have been outperforming, with VNQ up 14.1% and IYR 12.9% higher, whereas the S&P 500 has gained 8.3%.
Investors have turned to REITs for their favorable yields as an attractive alternative to falling yields in the fixed-income market. Specifically, VNQ shows a trailing 12-month yield of 2.97% and IYR comes with a 2.46% 12-month yield.
Lukasik is particularly wary about office and residential sectors, which he argues appear the most overpriced.
For example, the iShares Residential Real Estate Capped ETF (NYSEArca: REZ) shows P/E ratio of 36.9 and iShares Industrial/Office Real Estate Capped ETF (NYSEArca: FNIO) has a P/E of 42.6. [Residential REITs: Renters Aren’t Buying]
The Morningstar analyst is also cautious on self-storage REITs, and REZ’s portfolio has about 50% of its holdings allocated toward self-storage companies.
Nevertheless, Lukasik believes there may be some value in the retail REITs space. The iShares Retail Real Estate Capped ETF (NYSEArca: RTL) is the only retail-focused real estate ETF on the market. RTL has increased 12.5% year-to-date and comes with a 3.03% 12-month yield.
Potential investors, though, should be aware that iShares is planning to shutter FNIO and RTL, along with 16 other ETFs. [iShares Will Close 18 ETFs]
Additionally, looking ahead, the REITs space could face headwinds as interest rates rise.
“Higher rates could cause higher debt financing costs, put pressure on traditional after-interest expense measures of REIT cash flow, and lead to higher cap rates, which could pressure investment spreads,” Lukasik said. “Also, to the extent that low interest rates have diverted investor funds to REITs searching for higher yield, funds could flow out of REITs if interest rates rise, pressuring commercial real estate and REIT valuations.”
For more information on real estate investment trusts, visit our REITs category.
Max Chen contributed to this article.