The last several years have seen some dramatic swings in the REIT market. From a peak in February 2007 with yields below 4%, REITs fell more than 75% to a low in March 2009 when yields were briefly above 11%. Next came a nearly 200% gain to today. Currently, with dividend yields at 4.2%, it is hard to make a case for buying REITs. Not only is the yield far below average, but the yield spread to 10-year treasuries is only 0.94%, barely above the average spread of 0.91%.
Click to enlarge charts
With such low yields, I thought I would apply the same calculation I did for MLPs to estimate future returns of REITs.
- Total annual return = (1+g)(Yoriginal/Yterminal)^(1/T) - 1 + (Yoriginal+Yterminal)/2
g = growth rate of dividends
Yoriginal = current dividend yield
Yterminal = ending dividend yield (average yield level)
T = time frame
Unlike MLPs, where distributions have grown over time, dividends of REITs have actually declined a bit. However, there is no clear trend in the direction of dividends over several business cycles and so I am setting the growth rate of dividends in the equation to zero. Note that this means the primary source of returns from REITs as an asset class has come from dividends and not from growth in the underlying value of the business.
Click to enlarge
Y terminal in the equation is where we expect the yield to be at the end of the period. For this, I am using the average dividend yield, which has been 8.13%. While there is always the possibility that the average yield level will be lower in the future than the past, an ~8% level makes sense as that is about what is required to provide returns similar to stocks. A yield substantially below that would not compensate for the equity like risks that REITs have.
Using a seven-year time frame results in an estimate of -2.73% annual returns. This is below the 2.42% annual return estimate for stocks and far below that for MLPs. However, these estimates may not be completely comparable. The correlation between the dividend yield and future returns of REITs is not quite as strong as that of stocks and MLPs and we should leave a bigger margin for error in the estimates for REITs.
So even though real estate investment trusts are one of the first places investors look for dividends, they are not likely to provide satisfactory returns. The yield above that of treasuries is only 0.94%, a higher yield that is not enough to compensate for the higher risk. In addition, the yield is far below average, and for it to revert to a more normal level, prices would have to decline by around 50%. There will, of course, be opportunities in individual REITs, but investors should be very selective when buying.