REITs have historically provided high yields, but in recent years their yields have become depressed as REITs have behaved more like momentum plays than value plays. Unless “it’s different this time” which we doubt, REITs are due for a flat or negative performance to return to yields that are more competitive with risk free rates.
Mean reversion is a powerful and generally consistent force in financial markets, ably assisted by swings in investor psychology. With the second highest total return in 7 years and the lowest yield in 7 years, Equity REITS are not well positioned from an historical perspective to repeat their 2006 performance (see table below; click to enlarge).
Additionally, the 2006 total return is significantly greater than the 3, 5, 10, 15, 20 and 30 year average returns. That also bodes ill for a repeat of the 2006 performance in 2007 (see table below).
Anything can happen in financial markets, but over the long term, fundamentals and averages are key determinants of outcomes. As rational and sensible investors, we pay close attention to probabilities. The probabilities seem to be in favor of a less spectacular 2007 for REITs.
Investors who are rebalancing will sell portions of their REIT holdings and reallocate to lower performing sectors.
At year-end 2006 the market capitalization of U.S. Equity REITS in the FTSE NAREIT index was approximately $401 billion through 138 REITs (see table below).
The largest REIT for each property sector by market capitalization at year-end 2006 was [click to enlarge]:
According to a study by Green Street Advisors cited in the book "Unconventional Success" by David Swensen, REITs have experienced dramatic swings in premiums and discounts in the range of approximately +/- 30% to 35% since 1990 relative to the underlying value of their properties. Bear markets in physical real estate tend to produce discounts in REITs, while bear markets in stocks tend to create premiums in REITs as investors flow dollars from one type of investment to the other.
The best way for most investors to participate in the REIT sector is through a REIT index fund such as one from the list below.
Expense ratios are one of the few factors investors can control. Because of its high expense ratio, as well as its failure to produce above peer level returns in exchange for high expenses, we would avoid IYR.
We would favor Vanguard's VNQ for its low expenses, high yield, low price-to-cash flow and solid 2006 return.