REITs vs. Homebuilders -- Not What You Think

Roger Nusbaum submits: By now you know that Equity Office Property (EOP) is getting taken out. A lot of REITs are lifting in response. There had been chatter that this was a possibility; it has created some heightened excitement and now we will probably see a lot of are-REITs-right-for-you type articles.

My position on REITs has been same for a long time. Most clients own Equity Residential (EQR), EOP's cousin, which I first disclosed about a year and a half ago. A few clients less tolerant of stock market volatility own a second REIT.

Sometimes I see or hear commentary that lumps REITs in with the homebuilder stocks. This chart of EQR (as a proxy) compared to the Homebuilder SPDR (XHB) shows a very low and often negative correlation between the two.

I have never thought there was much of a fundamental connection but you can judge for yourself.

In addition to what I think is a fundamental difference there is also a difference in sentiment. Hot money seems to love to chase the homebuilders while REITs attract more staid capital. REITs, kind of like the Canadian income trusts, can create a false sense of security. REITs have utility and have a place in a diversified portfolio, but too much of anything is not a good idea. REITs had a rough run during the bubble years and they will have rough runs in the future.

Should you have exposure? Probably. But 20%? Not for me.

Comments

[NO DooDahs:]

Here's a chart of the relative performance of RWR (REIT ETF) over the SPY (S&P500 ETF). It's obvious that REITs and Homeys move in different directions. Consider that REITs as a class can include office buildings, shopping centers, apartments, hospitals, and all kinds of real estate, whereas Homeys are Homeys, and it's intuitively obvious that they shouldn't trade together.

www.billakanodoodahs.c...

2006 Nov 21 10:04 AM

[David Jackson:]

Interesting point, Bill. Perhaps the problem of the REIT ETFs is that they aggregate the residential REITs with the commercial REITs, and the two are arguably different asset classes. Commercial REITs would obviously move with the S&P because demand for commercial space is driven by business activity. But housing REITs may be different.

Well, at least in the short run... There was an interesting article in the WSJ a while back.

2006 Nov 22 07:19 PM

[Eric Vadon:]

Hogwash. If you look at EQR vs SPDR between inception and May, you'll find that the 2 stocks track one another. If you look at the 2 stocks between August and now, you'll find that they again track one another. There was a period during the summer (May - August) where SPDR got hammered. But to say that these 2 stocks are inverses of one another would be a mistake.

2006 Nov 21 10:50 PM

[Roger Nusbaum:]

take a look at a chart from 7/1/2000 to 12/31/2002, pretty good proxy for a market stress test, and see if you still feel that way. this can be done on bigcharts.com

2006 Nov 22 09:32 AM

[David Jackson:]

Roger, I know from your earlier articles that you focus strongly on dividend yields and bond yields. What are your thoughts about the current yields on REITs? I shorted some residential REITs after the Equity Office deal was announced because the yields are now at all time lows, and you can earn more by putting your money in a money market account. In other words, the risk-free rate is now higher than (at least the current) REIT yield rate! That means you can short the REITs and earn more on the cash than you'll have to pay in dividends.

I thought this article by Joe Weisenthal (The Stalwart) was particularly interesting:
usmarket.seekingalpha....

2006 Nov 22 07:11 PM

[Roger Nusbaum:]

David, relative valuations are not favorable compared to their own history I agree. Only owning one REIT, by and large, means I am not favorably disposed.

Interesting, what you say about being short with the money market interest paying the dividend. The move up in REITs has lasted for several years yet the market caps are quite small, EOP after the news is only $17 billion. I think Simon Property Group is the largest REIT at only $22 billion. I don't think the numbers here belie any panic buying (save for a day or two around the EOP news?).

It is almost as if REITs were initially part of a flight to safety then a beneficary of the change in tax law on dividends, even though they don't qualify.

The picture here I am painting is the old slowly turning ship analogy. If the group is going to go down I would expect it to take a while meaning your short would need some patience. Just an opinion:-)

2006 Nov 23 12:13 PM

[David Jackson:]

Totally agree. And the market is certainly bearing out what you said about the ship taking a while to turn (if at all!).

2006 Nov 28 03:13 PM

[NO DooDahs:]

Perhaps it's a theoretical issue that REIT ETFs merge residential and commercial classes; I haven't attempted to verify or disprove that any particular REIT ETF does or doesn't. I also don't read the War Street Urinal.

Regardless, it's a simple fact that RWR, a REIT ETF, regardless of its composition, has shown considerable outperformance over the broader market in terms of appreciation. This is not a new trend, it is a trend that goes back for several years and was unaffected - totally unaffected - by the collapse of homebuilding stocks. As long as the price is going up, shorting it is stepping in front of a moving train. It would seem to me that going from 80 to 90 in two months would outweigh the difference in yield from money markets to dividends.

Are you still short them?

Currently I am not long RWR, but I have a couple of positions near their stops and am considering RWR as a replacement. Been 100% long for quite a while ...

2006 Nov 22 10:05 PM

[David Jackson:]

Yup, I'm still short three residential REITs, not the broader REIT ETFs that also contain commercial and hotel REITs. I'm very unsure about these positions; as you and Roger point out, REITs have had a huge and sustained move and there's a lot of momentum behind them. But valuations based on yields now seem crazy, and in real estate yields and projected yields are everything (there are no growth surprises, right?).

2006 Nov 28 03:19 PM