Equity REITs Not Yet At Fair Value

In January of this year, we wrote that equity REITs were overvalued on the basis of yield and that they would likely decline by reverting to their mean yield. Since then, the REIT market has turned down – about 15-16%, so far. However, that is not enough to restore fair value. We believe that REITs must surrender another 1/3 to 1/2 of their market price to be fairly valued relative to 10-year Treasury bonds

The chart below shows the abrupt turn in market action for the group in the January-February time frame.

[click image to enlarge]

As with any mania, momentum becomes the sole focus at the expense of fundamentals. At some point, the market runs out of gullible souls, the momentum stops and then reverses. It’s been a downward slide since then, but there is still some ways to go.

In the long run, real estate is a yield-oriented asset. It cannot appreciate forever beyond certain relationships between its yield and market interest rates. Interest rates act as a sort of center of gravity for REITs in the long run.

In the past couple of years, REIT investors had forgotten about that orbital relationship between real estate yields and bond yields. Now the sector is paying the price of prior excess enthusiasm with a declining market.

The pain will not likely stop here. We estimate that the equity REIT sector has far further to decline to restore a rational and historical relationship to Treasury yields. That likely decline is an example of “reversion to the mean”, a powerful force acting on securities markets.

Consider this table that shows the average equity REIT yield with the average 10-yr Treasury bond yield for 7 prior years and 7 prior months of this year.

[click to enlarge]

You can see that in the four years of 2000 through 2003, equity REITs provided a yield that was about 150 to 240 basis points above 10-yr Treasuries. However, that positive yield spread broke down in 2004 and then become negative in 2006, where it is still today.

The positive yield spreads of 2000 to 2003 make sense to us. To restore those spreads one or a combination of these things must happen:

• REIT prices decline
• Intermediate-term interest rates decline
• REIT cash flows increase.

If we were to expect all of the change to come from REIT price declines, those declines would have to be in the 33% to 50% range.

There are four principal domestic equity REIT exchange traded funds worth considering when the time is right, and that time is not now. The right time is when the yield spread is at least positive 100 basis points, and preferably more.

The key ETFs are from Vanguard (VNQ), Barclays (IYR), State Street (RWR) and Cohen & Steers (ICF).

[click to enlarge]

We like VNQ the best. They have the lowest expense ratio, the most diversified portfolio, and the largest asset pool. They are not as actively traded as the Barclays, however, but we expect volumes to increase over time. Vanguard came to the game late and its ETFs are still catching up with Barclays and State Street in terms of trading volume.

Disclosure: Author does not own any mentioned security

Comments

[mylittlebut...:]

Great topic - I wish you had more history of the REIT yields relationship to the Treasury Yield to review. 2000 may or may not be a good baseline to compare the present with.

2007 Aug 15 04:19 PM

[QVM Group:]

I am the process of seeking more history and will publish an update when and if I can get data prior to 2000. Thanks for the observation. I agree, longer is better.

2007 Aug 15 05:50 PM

[Matthew Til...:]

Interesting piece. I recently conducted a similar analysis for the UK market, reaching much the same conclusion. Mean reversion would imply that long-term returns to real estate will probably lag the broader equity market. The only ammendment I would suggest is to maybe use a real yield for comparison, rather than a bond yield. Earnings or dividend yields are real yields, whereas bond yields are nominal yields, and therefore the comparison does not really make sense. Having said that, even if you use a real yield, the conclusion still holds (at least for the UK market).

2007 Aug 15 05:33 PM

[QVM Group:]

Comparison with other yields could be interesting. I may include that in a future update. The 10-yr Treasury is a conventional yield spread measure in the U.S., presumably because it has a constant and known credit risk level which cannot be said for non-sovereign debt.

2007 Aug 15 05:52 PM

[Zelvinn:]

Comparing Treasury Bond yields to a market variable equity yield is unfair. The only risk to the Treasury Bond is in the credit of the US. The risk to an equity related yield of an ETF is of another scale .

2007 Aug 16 12:40 PM

[QVM Group:]

www.qvmgroup.com/inves...

You are missing the entire point of yield spread analysis. The point is to compare a risk bearing yield to a risk-free yield. Rather than being "unfair" the comparison is essential, standard practice, and meaningul.

Please read my follow-up article for more.

If you prefer to compare REIT yields to some other yied yardstick, please tell me what you recommend and why. I will give it serious consideration.

2007 Aug 16 01:09 PM

[flstearns:]

Thanks for the ETF comparisons.

2007 Aug 16 02:16 PM