By Samuel Lee
The typical investor is virtually assured of experiencing some kind of disaster during his lifetime. Most are ill-prepared to weather major inflation, which hurts both stocks and bonds by raising discount rates. When inflation is high, investors reasonably worry about future macroeconomic stability, inducing them to demand higher real interest rates for lending over the long term. High real interest rates decrease the present value of all future cash flows. Nominal bonds are doubly hit because their fixed payments are devalued.
Good inflation hedges with decent yields are rare. Equity real estate investment trusts, or REITs, look like the rare exception. While their absolute yields are ugly, their yields relative to Treasuries look OK. Below is a chart of U.S. equity REIT yields minus the 10-year Treasury rate (a better comparison is to use real yields, but Treasury Inflation-Protected Securities only came into being in 1997). Not bad. Low interest rates, like alcohol, go a long way to lower one's standards. Should we buy REITs to hedge against inflation? While inflation hasn't been a problem since we entered the global balance-sheet recession, a properly balanced, robust portfolio demands that we load up on insurance when it's cheap. This chart suggests inflation protection can be had for a reasonable price by purchasing publicly traded real estate.
Actually, no. I'm showing a variation of the Fed model, normally used to value the broad stock market. The problem with this model is it doesn't explain returns over the long run. In his classic "Fight the Fed Model" paper, AQR founder Cliff Asness convincingly argued that the model is grounded on faulty theory and poor empirical support. And the nature of REITs has evolved over time. Their inflation-fighting properties are probably intact, but they're swamped by other, less appealing qualities such as higher market correlations and lower dividend yields, which have historically accounted for nearly all their real returns.
Before we get into those, let's review the nature of REIT cash flows and how those cash flows evolve during different economic scenarios. REITs can be thought of as a special kind of long-duration, inflation-adjusted bond (the same can be said of stocks). Unlike most bonds, however, their payments aren't fixed. REITs are required to distribute most of their earnings to shareholders in exchange for minimal taxation at the corporate level. Without the ability to retain a good portion of their earnings, REITs usually borrow money or issue shares to fund their property purchases. By generating earnings from multiyear leases (and, to a lesser extent, from capital gains arising from selling properties), REIT cash flows are fairly predictable over several years. In addition, many REITs (at least in the United States) have clauses in their leases that enable them to raise rents at a rate tied to the Consumer Price Index. Even in cases where REITs don't have such clauses, they're able to pass through inflation with a lag as leases run off and are renewed at prevailing market rates.
It's clear, then, why REITs should thrive in high-inflation environments. First, they can pass on price increases to tenants. Second, they issue nominal bonds to invest in hard assets, so their balance sheets and cash flows benefit from inflation. It's also evident that REITs should display some sensitivity to interest rates, as they bear bondlike qualities.
Weirdly, for much of their history, REIT yields seem to have moved to the beat of their own drummer, showing a minimal relationship with changes in long-term interest rates. For decades, they averaged somewhere in the neighborhood of 7%, with the rare blowout to double digits--rich payouts for an inflation-protected asset with low correlation to the rest of the market. Then in the early 2000s, REITs experienced a regime shift, and their yields settled down near 4%.
This is important to know. A common argument for REITs is a simple appeal to long-run historical returns. From the beginning of 1972, when the FTSE NAREIT US Equity REIT Index data begin, to the end of August 2013, REITs returned 11.9% annualized. U.S. stocks returned about 10.3% annualized over the same period. REITs earned high returns because their yields were high. It bears repeating that almost all of the real return REITs have produced can be attributed to dividends. Price appreciation only kept up with inflation. Something about REITs changed in the early 2000s. My theory is that for most of their existence REITs were a small, illiquid asset class, neglected by the mainstream and known largely to a small set of venturesome investors. The asset class gained mainstream acceptance as the real estate bubble inflated. Even though the bubble eventually popped, REITs were established as a major asset class, easily accessible, and now ensconced in the big, conventional market indexes like the S&P 500. The abundant accessibility and liquidity surrounding REITs seem to have permanently altered their risk-return characteristics.
A simple way to test this is to see how REITs' comovement to the market has changed over time. I calculated a rolling three-year market beta, controlling for REITs' exposure to size, value, momentum, and interest-rate risks, to better isolate pure market exposure. The change is striking: REITs went from an average market beta of 0.5 to over 1 in the early 2000s and have stayed there since. Over this period, REITs went from small-cap, deep-value stocks to larger-cap, growthier stocks.
REIT expected returns are now much lower than they were for most of their history. Unless you're optimistic that REITs can grow per-share dividends at above the rate of inflation, overcoming their structural inability to retain earnings, REIT real returns will likely disappoint. Yields have historically been the best predictor of future REIT returns. At today's prices, REITs as a whole can be realistically expected to return around 2% to 3% after inflation.
Anyone who buys REITs on historical risk/return characteristics without considering the fundamental drivers of return and potential changes to market structure is being reckless. A deeper look strongly suggests that REITs' diversification powers are down and so are their expected returns. While we can still expect REITs to respond positively to inflation--all else held equal--it would be a mistake to think they'll exhibit the kind of anti-inflationary properties they exhibited back in the 1970s.
If you're worried about inflation, I have two suggestions: cash, which has historically been among the best inflation hedges out there because the Federal Reserve raises rates in tandem with inflation, and conventional equities at sensible prices.
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