As the tone of panic upset the domestic stock market last month, real estate investment trusts (REITs) held up pretty well. The S&P 500, as measured by the SPDR S&P 500 Index ETF (SPY), lost 2.59% in January while the Vanguard REIT Index ETF (VNQ), which is composed of traditional equity REITs, rose 4.26%.
Then February came a-knockin with intensified correction fears. Coming off a week of flight-to-safety maneuvers where emerging market currencies were crushed, Monday's release of weaker-than-expected December 2013 ISM manufacturing data gave investors all they needed to continue to flee stocks.
On Monday February 3, 2014, the S&P 500 dropped off over 2%, while the VNQ sunk just over 1.5%. By late-afternoon on February 4, REITs recovered to a loss of just over 0.5% for the month, while stocks recovered for a ~1.5% loss on the month.
While REITs held up slightly better than the overall market on Monday, the market trading data suggests that correction fears disregarded the market vs. REIT year-to-date divergence and punished sectors the board.
Manufacturing Data May Improve By Spring
The December ISM manufacturing data came in at 51.3, which means that the sector growing, albeit at a slower rate than what the market expected. A reading above 50 indicates growth and as reported, December 2013 marked 56 consecutive months of expansion.
The market was spooked because it expectations were higher, however the divergence between the data and expectations was attributed mostly to weather.
The ISM report stated:
"A number of comments from the panel cite adverse weather conditions as a factor negatively impacting their businesses in January, while others reflect optimism and increasing volumes in the early stages of 2014."
The index reading is comparable to GDP growth of 2.7%, which is slightly less than the domestic 2014 Q4 rate of 3.2%.
In short, the economy is still improving and manufacturing data continues to relay the story of growth, albeit at below-average December expansion numbers that are attributable to adverse weather conditions.
With this understanding, investors should expect better manufacturing data as the weather improves, inventories catch-up and the current economic expansion continues.
Why REITs Will Continue To Outperform The S&P 500
The S&P 500 closed on Monday February 3, 2014 at only 14.4x 2014 earnings, for a forward earnings yield of 6.95%. While the market's valuation is low, REITs may continue to outperform due to the thesis that a strong dollar and low 10-year Treasury rate reduces the required risk premium in REIT yields and other high-yield investments.
Over the past six-months, the 10-year has been flat while Q4 2013 general share collapse of the REIT market pushed yields upward. The REIT dividend of the following three companies were stable until recently, where all three were raised (see recent yield spike on chart).
Using these three REITs for analysis, the chart below showcases four trends.
1) Flat 10-year yield.
2) Contracting share prices in Q4 2013 as dividends were stable.
3) Selected REIT yields moving in-line with 10-year yield.
4) Yield premium divergence with recent dividend growth.
In looking at the recent yield spike due to the dividend growth, a clear divergence can be noted. It could be suggested that these companies, as well as the equity REIT market as a whole due to its nature reliable dividend growth in times of economic expansion, have yields that suggest a larger-than-warranted yield risk premium.
As such HCP, VTR and CPT, other traditional equity REITs who are currently raising the dividend and the entire equity REIT market, as measured by the VNQ, has room for an above-average short-term total return.
Each of the three REITs mentioned above have outperformed the VNQ year-to-date and have improving fundamentals that should attract continued share price appreciation.
As noted by the previous chart, the 2014 pricing trend has not adjusted for the increase in current yield, which gives investors a great reason to buy these stocks.
The yields at HCP, VTR and CPT are also much higher than the average REIT yield.
While prices may seem high relative to the S&P 500 performance this year, REITs are still coming off of a bad 2013 and are sitting close to two-year lows.
REITs have outperformed the market year-to-date and should continue to do so as the economy expands and treasuries remain strong. While today's manufacturing data was used as an excuse to further negative sentiment in the market as a whole, over the long-term the market is very inexpensive (~7% earnings yield) for a bull-market that remains intact.
The strong dollar, evidenced by global currency risk and a rush to safety, has widened the yield spread between REITs and risk-free treasuries as measured by the 10-year. With REIT yields improving year-over-year, as evidenced by the annual dividend raises mentioned above, the yield spread can only remain constant or revert back to the mean with an increase in REIT pricing.
With this understanding, astute investors may find above-average short-term opportunity to invest in domestic equity REITs with recently increased dividends. In this regard, a few great selections include the aforementioned stocks HCP, VTR and CPT.
Bonus: HCP Yield Risk Premium In Perspective
In terms of HCP versus the 10-year Treasury yield, the yield risk premium has averaged 256 basis points since 2011. In calculating the forward expected yield of HCP on a monthly basis, updated for announced dividend raises, one can note the history of the risk premium in terms of the yield spread basis points.
As noted by the chart above, the risk premium started very low in 2011. HCP's yield started the year just above 5%, while the Treasury rate declined dramatically. As such, the risk premium increased.
The risk premium then declined in 2012 and continued into 2013 until the "rising rates" theme quelled the run starting in May.
The rising rates theme saw treasuries weaken, HCP's price came under pressure weakened further (as well as REITs in general), which increased the yield spread to above 300 basis points by year-end.
In 2014, the strong dollar increased treasury demand in the face of the taper and as such, REITs advanced. As noted in the HCP history however, with the 2014 dividend raise the yield spread was once again increased near 2013 year-end levels (291 bps).
In the chart below, the increase in the yield risk premium is seen on both fronts as the HCP dividend raise took effect and "King Dollar," as Larry Kudlow would call it, came back into vogue.