35 Years of Yield Spreads: REITs vs Treasuries

Includes: ICF, IYR, RWR, VNQ
by: Richard Shaw
Yesterday, we wrote about overvaluation of equity REITs based on a 7 year analysis of yield spreads between equity REITs and 10-yr Treasury bonds. That article was a continuation of our avoidance recommendation made on Jaunary 30th of this year. Our conclusion was that equity REITs have far to go before reaching fair value, even though they have declined some 15+% this year (and some 27% from their highs this year).

We recommended avoiding equity REITs as a class until the yield spread over Treasuries was 100 basis points or more.

Several people wrote to us with concerns about our analysis. We would like to address those concerns here. They raised these issues:

  • Treasuries are not a good comparator and stock yields should be used instead
  • 7 years isn’t long enough a period to draw strong conclusions
  • Yield is only part of the factor, the other being the market value of the underlying properties.
  • We believe that Treasuries are a good comparator, because they have a known and constant credit risk (essentially zero), unlike stock and corporate bond yields that have significant and varying credit risks. Treasuries are a standard for yield spread analysis. The point of using Treasuries, and not some other credit, is to measure the amount of yield over and above the negligible credit risk of Treasuries that is being provided by REITs for taking the additional risks of REITs.

    We can’t be certain that 10-yr Treasuries are the best choice among Treasuries. Longer is probably not a good idea, but shorter may be more appropriate. However, 10-yr Treasuries seem to be a default choice in many yield spread studies.

    We agree that 7 years provides a limited window, so we have expanded our study to 35 years (1972 - 2006) as shown in the table and chart below.

    [click image to enlarge]

    The longer term data confirm our view that a 100+ basis point spread is an appropriate target for fair value of equity REITs. You have to look very far into the past to find negative yield spreads lasting for more than 1 year, and that was a time of exceptionally high interest rates that would not be considered normal.

    We disagree that yield (or cap rate as real estate investors might call it) is not an adequate indicator of value. If the underlying properties are creating inadequate yield, then they are also overpriced. Our thesis is that real estate is ultimately about funds provided by operations (and that translates to cash yield). Real estate simply gets out of line with fair value from time-to-time based on investor focus that is too strong for too long.

    The most recent real estate bubble was driven by low interest rates, sloppy credit underwriting, too much cash chasing opportunities, and perhaps a post 9/11 aversion to ordinary stocks. That game is now over and investors are beginning to demand yield again. However, investors are not done marking down prices, because they aren’t yet getting adequate yields. Alternatively, investors could mark up Treasury bond prices to lower the bond yield which would widen the REIT-Treasury spread.

    Something similar happened in the early 1990’s after the Tax Reform Act of 1989. Prior to the Act, real estate syndication and the related tax shelter effects had proliferated to the point that Congress reduced the tax shelter opportunities in real estate. Real estate promptly tanked and created massive financial problems for major real estate holders. Before that period of decline, direct real estate investment had become so optimistic and dependent on tax shelter that buyers were agreeing to substantial negative cash flow on purchases, such that only unreasonably strong appreciation could make the investment work. The Tax Reform Act was the event that broke that cycle and revived concern for positive cash flow.

    In this cycle, cash flows remained positive, but they were too low. The inverted yield curve begun last year and the credit crisis of this year are the events that have revived investor interest in better risk adjusted yields from equity REITs.

    If we limit our yield spread target to 100 basis points, then we would expect further equity REIT price declines of 25% to 40% to reach fair value. Alternatively, a 100 basis point reduction in 10-year Treasury bond yields or some combination of REIT price declines and bond price increases would reestablish the needed spread.

    The leading equity REIT index exchange traded funds are (NYSEARCA:VNQ), (NYSEARCA:IYR), (NYSEARCA:ICF), and (NYSEARCA:RWR).

    Disclosure: Author owns no REITs or REIT funds at this time.