The lackluster performance of REIT funds this year has been a sharp contrast from their previous market-beating returns since 2009. REIT exchange-traded funds like Vanguard REIT Index ETF (VNQ) outperformed the S&P 500 in each of the past four years, often by a significant margin. However, year to date through the end of November 2013, REITs have only returned 2.2% compared with SPDR S&P 500's (SPY) 29% return. It's been a bumpy ride, too, as VNQ's one-year standard deviation was 80% greater than SPY's, which is well above the three-year average difference in volatility. Earlier this year, after the Fed first mentioned that it may scale back its bond-buying program, REITs slid more than 15% between May 20 and June 20.
Fears that interest rates will increase are largely to blame for the category's heightened volatility and diminished performance. Because REITs must pay out most of their income as dividends in exchange for their advantaged tax treatment, they rely heavily on short-term borrowing for growth. For REITs, higher rates mean more-expensive debt servicing and less business reinvestment, as well as less cash to pay out to investors. REITs also could fall out of favor if their yield doesn't keep pace with Treasuries, putting downward pressure on the sector's valuation.
However, concerns about REIT performance during a rising interest-rate environment may be overblown. An examination of two major monetary-tightening cycles, 1994 and 2004-06, gives important historical perspective.
Learning From the Past
Looking back 20 years to 1993 shows how REITs performed in a rising interest-rate environment coupled with muted economic growth. At the end of 1993, the savings-and-loan recession was ending. Through the end of 1994, the Fed began monetary tightening, and the 10-year Treasury yield increased more than 2.6 percentage points. REITs kept pace with the relatively flat S&P 500 from the beginning of the Fed's policy change in February through July, but then lagged behind the broad market and were slower to join the rally once the 10-year yield peaked at 8% in November 1994.
Conversely, REITs significantly outperformed the S&P 500 during the period of gradual rate increases from June 2004 to August 2006, gaining more than 65% compared with the S&P 500's 21%. During this time period, rates increased alongside a booming economy--a more typical scenario, as the Fed tends to raise rates when the economy is strengthening. Higher rates were offset by the surging housing market and broad gains in the equity market at large.
The historical evidence suggests that economic growth is more important to REIT performance than interest-rate changes. For further examination, I calculated a rolling time series of six-month changes in the 10-year Treasury yield from 1994 to the end of September 2013 and sorted the observations into quartiles. The first quartile included periods that increased by 0.40 percentage points or more, and were considered to be rising interest-rate environments (this quartile included notable rising-rate environments, such as the bond sell-offs of 1999 and 2013). Conversely, declining interest-rate periods fell into the bottom quartile, with decreases of 0.09 percentage points or more (this quartile included multiple time periods in 2010 and 2011). During the rising interest-rate periods, REITs (as represented by the Dow Jones U.S. Select REIT Index) posted average six-month returns of 9.98% compared with the S&P 500's 11.42%, but those returns were negative 1.99% compared with the S&P 500's negative 2.74% during declining interest-rate periods.
These results reflect that rates tend to increase when the economy is experiencing accelerated growth, and to decline during a market downturn or recession. REITs are cyclical businesses: An economic boom means higher occupancy and the ability to impose steadily increasing rates on tenants. Historically, REITs have shared in the growth of the broad U.S. market during bull markets. A recent study (pdf) by Cohen & Steers, a company that specializes in real estate investments, had similar findings of 10.8% annualized REIT returns over six discrete periods of increasing U.S. Treasury yields since 1979. The study examined 135 individual months between 1979 and 2012 when the 10-Year Treasury yield was on the rise, and it found that REITs posted greater cumulative returns than the S&P 500. The firm's study also showed that real estate values increase and REIT cap rates decrease during rising interest-rate environments, indicating market optimism about the sector's ability to grow during times of strong economic growth.
If REIT fundamentals and economic growth are more important than interest rates, that means both good and bad news for REITs. There's plenty to like about the REIT sector's fundamentals. The current U.S. economy is expanding enough to grow demand for real estate incrementally but not fast enough to encourage real estate developers to build new properties. As a result, REITs are experiencing steadily increasing demand for rental properties without the downward pressure of extra property supply entering the market. Stronger-than-average economic growth might trigger new property development, but REITs did very well from 2004 to 2006 during a period of booming economic growth and gradually rising 10-year Treasury yields. However, the U.S. economy's sluggish growth does not inspire confidence that a near-term uptick in rates would be offset by growing REIT cash flow.
An important distinction between the 1994 and 2004 monetary tightening and the current uptick in 10-year Treasury yields is that in previous cycles, there was not significant yield-curve steepening because yields rose along the entire curve. This year, the yield curve steepened on the expectation of higher rates when the Fed eventually tapers its quantitative easing program.
Happily, the market's fear of interest-rate increases means that REITs are now relatively attractively valued. The U.S. market as a whole is currently considered pricey: Morningstar's equity analysts find that this market is trading at 1.04 times fair value--above the historical average. The Shiller P/E, another valuation metric, recently hit 25 compared with a long-term average of 16, which further indicates that the market is overvalued. Following several months of price corrections, REIT valuations are now more attractive than most areas of the market. Funds like Vanguard REIT Index ETF traded at an average premium of 5% to 10% in recent years on the back of the REIT sector's strong performance, but our equity analysts find that the real estate sector is roughly fairly valued today for the first time since 2011. Readers can examine Morningstar's fair value estimates in more detail using Morningstar's market valuation tool.
What's To Be Done?
Investors who have held REIT ETFs until the present should remember why the sector was included in their asset allocations. It is difficult, or arguably impossible, to predict the direction interest rates are headed. Income alternatives like REITs are utilized to provide diversification and inflation protection while generating above-average yield. Investors who have determined that REITs have an appropriate place in their portfolios should consider rebalancing instead of ditching the sector, as the rationale behind holding real estate has not changed in the face of rising rates. At its core, rebalancing will help control the risk in a portfolio. The varying performance of asset classes over time causes a portfolio to shift away from its target asset allocation. By trimming back assets that have grown and returning capital to beaten-down investments, investors make sure they aren't straying from their target asset allocation. Rebalancing also takes advantage of the mean-reverting nature of the market: buy low, sell high.
That said, investors should remember that REITs have become an increasing part of broad equity ETFs, and now account for 3.4% of Vanguard Total Stock Market ETF (VTI). Ibbotson's target asset allocations suggest putting between 3% and 5% of one's total portfolio in domestic REITs. Any allocation exceeding 5% could be considered an overweighting.
There are several REIT ETFs for investors to choose from. We like Vanguard REIT Index ETF's VNQ diversified exposure to the sector. Its 120-plus holdings encompass almost all of the real estate sector's total market capitalization and include more mid- and small-cap stocks than competitors. VNQ charges a 0.10% expense ratio, which is only bested by Schwab US REIT ETF (SCHH), which costs 0.07%. SCHH excludes the smaller REITs present in VNQ's portfolio, but 90% of their holdings overlap. We prefer VNQ's broader selection of REITs, but SCHH is an excellent alternative.
A popular, but riskier, ETF is iShares U.S. Real Estate (IYR), which costs a pricey 0.46%. It is the only REIT ETF to include specialty REITs like mortgage (7%), timber (5%), prison (0.5%), and tower (5%) REITs. Mortgage REITs and other specialized firms are REITs in name only, following very different business models and driven by factors other than the fundamentals of the domestic real estate market. Mortgage REITs are more rate-sensitive than equity REITs and have declined even more sharply since the Fed's announcements.
The small-cap segment of the market is tracked by IQ US Real Estate Small Cap ETF (ROOF), which costs 0.69% a year. Small-cap REITs have returned more than 13% year to date, handily beating the larger companies that dominate market-cap-weighted ETFs. Pure mortgage REIT exposure is available through iShares Mortgage Real Estate Capped (REM), which charges a 0.48% expense ratio.
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