The global markets continue to struggle to price financial assets based on the direction of interest rates and the actions of the Federal Reserve. It was widely expected that the Federal Reserve would begin tapering its $85 billion a month Large Scale Asset Purchases Program (LSAP) otherwise known at Quantitative Easing. However on Wednesday, the Federal Reserve's decision to not taper caught markets by surprise and interest rate sensitive assets (and assets sensitive to the US dollar) rallied on the news.
The battle field of interest rate uncertainty has shifted overtime and it appears that REITS have now found themselves front and center, which up to this point has largely been focused on fixed income securities and hard assets such as precious metals. REITS have both characteristics of fixed income and equity based on their business structure including contractual obligations (leases) and management's ability to grow and occupy properties with leaseholders. The rise in interest rate volatility has clearly contributed to the recent weakness in REITS.
REITS as represented by Vanguard's REIT Index ETF (VNQ) rallied 3.4% on Wednesday's "no taper" news compared to the 1.2% jump by the S&P 500 (SPY). However, since the day before Federal Chairman Ben Bernanke's May 22nd congressional testimony, which hinted on how a taper of the LSAP program would work, REITs corrected approximately 15.9% (through June 20) and 10.8% as of yesterday's close. Over the same time period the S&P 500 and S&P 600 Small Cap Value (IJS) indices are up 4.1% and 7.4%, respectively.
One could think of the 10-Month Moving Average (10MMA) as the current battle front. With the recent pullback of the REIT index, VNQ closed 5.0% below the 10MMA at the end of August. The index has been above its 10MMA for 20 months and it is the first domestic equity group to fall below its intermediate average. Since the 10MMA bottomed in July of 2009, the average has increased 258%. That reflects an impressive compounded annual growth rate of 25.5%.
In the figure below the red dashed line represents the trailing 10 months of prices. Prices are adjusted downward to reflect dividends received and therefore a proxy for total return.
Figure 1: Monthly Total Return Performance of VNQ
Data Source: Yahoo!Finance
One should expect this trend to slow to reflect more historical growth rates. A review of the largest holdings that make up ~60% of the market capitalization of the Vanguard REIT Index, indicates that the fundamentals largely reflect moderation from here. Below are three factors that we think will keep REIT performance subdued.
- REIT dividend yields as a group are near their bottom at 3.3% compared to a floor of ~3.0% set over the past 9 years. This would imply that future price gains will be driven by dividend growth more so than changes in benchmark interest rates. [Figure 2.]
- Dividend per share annual growth has normalized and has averaged ~8% over the past 4 quarters. While we are unclear on the sustainability, the growth trend has been rising and the current dividend yield estimate of 3.3% is based on year-over-year growth in dividends of ~10.0%. [Figure 3.]
- Lastly, the spread between the REIT dividend yield and the 10-year Treasury is neutral. The current spread between the 10-year has been tightening and is currently at 0.5%. Since the 1990s the average has been approximately 1%. However, it is when the spread is negative that the index has seen pull backs such as the case was in March and June of 2011 when the spread was (0.2)% and (0.05)%, respectively. [Figure 4.]
Based on the above considerations, a fair value range using a dividend range of 3.0% to 3.75% would imply prices for VNQ from $60 to $75. While that range is rather wide, the bias towards firming interest rates at higher levels would argue for some conservatism given there is more downside risk due to market pullbacks (equity component) than a fall in interest rates, which wouldn't necessarily increase the upside potential based on the perceived 3.0% dividend yield floor.
Note that the following figures are based on aggregate individual REITS, equal weighted, that make up approximately 60% of the market capitalization of the Vanguard REIT Index. We have only included those REITS that had data for the entire period, which creates a positive bias relative to the investable ETF, but should provide better operating history for investment analysis. The group data has been indexed for clarity purposes.
Figure 2: REIT Dividends and Price History
Figure 3: REIT Dividend per Share Year-over-Year Growth (Blue Line)
Figure 4: REIT Group Dividend Yield and 10-Year Treasury Yield
Divergence is Cleared
A last point regarding the risk-to-reward profile, it is noteworthy to point out the performance divergence between REITS and traditional equities. From 2005 the correlation between VNQ and the S&P 500 has been .95 (similar to the Russell 1000 Index (IWB)). After the 10-year Treasury yield bottomed last July at 1.5%, REITS have given away all the outperformance since 2010.
While it is not clear how REITS will perform moving forward, clearly much of the overvaluation has been cleared since late May. With VNQ bottoming around $63.50 in August we also have some clarity on the markets estimation of fair value. Rather we would expect a higher chance that the trend in the broader general market to pull back. The S&P 500 forward price-to-earnings (P/E) based on Factset data dated September 20th was 14.6X, which is above the 5-year and 10-year average of 12.9X and 14.0X, respectively.
If REITS pull back significantly with any broad market decline and fall below $60, we would have to look closer at REITS as a buying opportunity contingent on the reason for the pullback.
Figure 5: VNQ versus SPY (Total Return Comparison)
The recent pullback in the REIT Index is largely a positive as valuations based on dividend yields were stretched in May. Recent lows set by VNQ at $63.50 reflect an estimated dividend yield of 3.6%, which likely indicates a reasonable fair value at this time. This is a 0.8% spread over the 10-year Treasury which is closer to the longer-term average of 1%.
However, with prices currently trading in the proximity of the 200 day moving average of $68.85 (a proxy for the 10MMA), there could be some volatility near-term especially as monetary policy remains uncertain. Therefore the biggest risk currently to the REIT Index ETF is tied to market risk as interest rate risk has largely been resolved (for now). The bigger question for investors is whether REITS will stabilize and rebound with equities or do REITS roll over with any broad market pull back? With the S&P 500 at 14.6X its forward 12-month earnings , which is above its 5 and 10 year averages, suggests the risk-to-reward is not favorable. Regardless, any meaningful pullback in VNQ below $60, without a significant interest rate shock, should provide an attractive entry point.
Additional disclosure: Clients of Smith Patrick Financial Advisors own VNQ and RWX at the time of this writing. This is article is written for informational purposes and we believe investors should perform their own due diligence before making investment decisions.