Over the past 20 years, equity REITs have yielded more than 10-year Treasury bonds most of the time. When REITs do not yield more than 10-year Treasuries, it may be time to be watchful for a possible drop in their price. The yields are very close right now and Treasury rates are rising.
It seems logical to us that REITs should produce more income than Treasuries, considering the greater risk of default, and the expansion and growth limitations of real property versus other sorts of businesses.
This chart shows yield data for 20 years for all US equity REITs (source: National Association of Real Estate Investment Trusts) and for the 10-year US Treasury bond (source: Saint Louis Federal Reserve Bank).
The spread between REIT yields and Treasury yields over the same 20 years is shown in this chart. A wide spread propels REIT prices upward, as yield motivated investors flock to higher yielding assets. On the few occasions when REITs yielded less than 10-year Treasuries, the price of REITs tended to subsequently fall.
You can see in the next chart that when the yield spread became negative in 2007, REIT prices began to decline, well before the 2008 stock market crash.
When the spread was negative in the 1997-1998 range, REIT prices declined subsequently.
It is a bit harder to see on this chart, which is not a semi-log chart, that in the 1993-1995 range, when the yield spread was minimal and touched zero, the price of REITs weakened substantially on a percentage basis.
That brings us to Thursday December 16, 2010 when the yield on the Vanguard equity REIT index was 3.52% and the 10-year Treasury was 3.47% -- still positive, but minimal. Considering past price behavior in relation to yield spreads, we think VNQ and other broad equity REIT funds, such as IYR and ICF deserve close watching for possible tactical exit.
The consensus view is that Treasury rates will rise. Unless REIT incomes rise faster (and they can’t change as rapidly as interest rates can change), probabilities suggest REIT prices may be a bit toppy.
There may also be some risk of mean reversion negatively impacting equity REIT prices in the not too distant future.
Not only are Treasury rates bound to revert to mean levels at some point, so are REIT yields likely to do the same in harmony with Treasuries.
If we look at the history of equity REIT yields and 10-year Treasury rates from January 1972 through November 2010, we see REITs yielding a bit more than Treasuries over long periods. REIT yields did not go down as far to its minimums as Treasuries have done, nor did they rise as high as Treasuries at their maximum. However, average and median yields for REITS were at or slightly above that of Treasuries over the 38 years.
- REIT average: 7.25%; Treasury average: 7.24%
- REIT median: 7.44%; Treasury median: 7.03%
- REIT maximum: 13.07%; Treasury maximum: 15.32%
- REIT minimum: 3.40%; Treasury minimum: 2.42%
With Treasuries facing a mean reversion to perhaps 4% within a year, and perhaps 5% in two years or less; and with REITs yielding 3.52%, REITs need to produce a good deal more Funds Provided By Operations (the source of distributions), or decline in price to keep up with Treasuries.
Our View in 2007:
We published a similar view on September 24, 2007 as the end of a series of articles on risks in REIT prices that we began in January of that year. In that article “REITs vs. Treasury Yields: Something Has To Give” published at Seeking Alpha, we said,
“We have been expounding our view that REITs are overvalued since January of this year. We continue to believe that is the case, even in the face of last week's Fed rate cut and strong rise of REITs.
REITs are well below their historic yield levels, which suggest mean reversion will bring their prices down unless they can substantially increase cash flow and distributions.
REIT yields are below 10-year Treasury yields, which has occurred only 1/3 of the time over the last 30 years, and most of that was quite a while ago. Either REIT yields must rise or Treasury yields must fall to restore dominant historic relationships. Even though the Fed cut short-term rates last week, the 10-year Treasury rates increased while REIT yields fell, increasing the misalignment.
...our longer-term view compels us to wait for a better buying opportunity based on yield comparisons [between REITs and 10-year Treasuries].
Unfortunately, logic doesn't always prevail in the short-term. If the market wants to go in a particular direction, it will, at least for a while. Ultimately, though, logic does prevail — we just don’t know when.”
In the past couple of months, 10-year Treasuries have risen and REITs have fallen in sympathy, as did bonds (proxy: BND). The S&P 500 index (proxy: SPY) moved ahead, as did the S&P 500 Dividend Aristocrats index (proxy: SDY).
Dividend stocks show more short-term sensitivity to Treasury rates than do stocks generally, because they were also bought with a substantial yield motivation. Like REITs, dividend stocks cannot immediately adjust their payout to keep pace with interest rate changes, so their prices swing a bit in response to changes in interest rates. However, because dividend stocks may be perceived as better able to grow profits, and certainly to modulate payout, they do not show as much price sensitivity to interest rate changes as REITs. Note that REITs effectively pay out nearly all their cash flow at all times, whereas dividend stocks generally pay out less and can make payout adjustments at a faster pace than REITs in response to changes in ambient interest rates.
Our Current View:
We have some VNQ exposure in some accounts, as well as some individual REITs, which we are cautiously watching. They are protected by stop loss orders, as are all of our positions in liquid listed securities, but interest rates can change rapidly and change the direction of REIT prices quickly.
We are not adding to REIT index positions at this time, and may reduce or eliminate positions if Treasury rates continue their climb.
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