This week, my call focuses on REITs. With yields low and likely to stay that way for the foreseeable future, everyone is searching for income wherever they can find it. One of the biggest beneficiaries of this “stretch-for-yield” has been the REIT industry.
Since its 2009 lows, the S&P REIT industry has gained roughly 220%, more than twice the gain for the broader US equity market. This outperformance has continued in recent months. During the first six months of 2011, REITs gained around 11%, about double the S&P 500’s advance.
The rally has left REITs looking expensive by virtually every metric. Based on price-to-book, the industry trades at a premium to the broader market, while historically it has traded at a 10% discount (during the lows in 2009, it was trading at a 40% discount!).
REITs look particularly expensive compared to other financial companies. In the past, REITs have averaged a 45% premium to other financial stocks. Today, REIT valuations are around double those of the broader financial sector. While some would suggest that declining return on earnings (ROE) at many banks argues for a bigger premium for REITs, it is worth highlighting that as recently as the summer of 2009, the REIT industry’s premium to the financial sector was roughly half of where it stands today.
Nor is it the case that the REIT premium is being driven by a significant improvement in profitability. ROE for REITs is around 9.25%. While this is a big improvement from the industry’s 2010 lows, it is still below the five-year average.
What does appear to be driving the current premium is the search for income at any price. As investors stretch for yield, REITs are a natural beneficiary. Yet even on this measure, the industry looks expensive. The 12-month trailing dividend yield on US REITs was 3.38% at the end of June, well below its 10-year average of 4.75%. Even compared to Treasuries, REIT’s yield does not look particularly attractive. Historically, the REIT industry has yielded around 70 basis points (bps) more than the 10-year Treasury note; as of the end of June, the premium was less than 40 bps.
Today, investors appear to be paying too much for too little income in a number of asset classes, including REITs. As such, I would favor underweighting REITs relative to other financial stocks. For investors still struggling for yield in today’s low-rate environment, I believe there are better options, including US municipals and corporate bonds in the fixed-income market, and mega caps in the equity space. All of these options offer the potential for a similar yield at a more reasonable price (Possible iShares solutions: ICF, IYR).
Past performance does not guarantee future results.
In addition to the normal risks associated with investing, narrowly focused investments typically exhibit higher volatility. REIT investments are subject to changes in economic conditions, credit risk and interest rate fluctuations. Bonds and bond funds will decrease in value as interest rates rise. An investment in the Fund(s) is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. A portion of a municipal bond fund’s income may be subject to federal or state income taxes or the alternative minimum tax. Capital gains, if any, are subject to capital gains tax.