A Closer Look at REIT-Treasury Yield Spreads (1971- Present)

We advised investors generally to avoid US equity REITs in January 2007. At that time, we felt they had gone too far, too fast and were bound to suffer a reversion to the mean, by not performing or by declining. They went down a lot.

In August 2007, we reiterated our concerns that REITs were overvalued due to their distribution yield being too low relative to 10-year treasuries.

In January 2007, the yields of equity REITs were 1.36% below 10-year treasuries. In July 2007 (the last month before our August article), REIT yields were 0.44% below 10-year treasuries.

We recommended staying out of REITs until they were fairly valued with a 1.00% or greater yield than 10-year treasuries.

We did not say then, but clearly if an investor saw a steady shift from lower to higher yield by REITs, a gradual return to the class could have been considered. In fact, those who took that approach in 2008 have done well, as equity REITs have outperformed the overall US stock market.

YTD REIT Price Performance:

The chart shows how stocks, bonds and real estate (REITs that is) have done relative to each other year-to-date (April 22, 2008). Stocks are represented by the S&P 500 index (SPY). Bonds are represented by the Lehman Aggregate Bonds index (AGG). Real estate is represented by the FTSENAREIT index (VNQ).

Interestingly, the chart comparing total equity REITs (VNQ) with REIT sector funds for residential (REZ), industrial (FIO) and retail (TRL) shows residential as the clear leader.

Recent Yield Spreads:

Equity REITs crossed over from yields lower than Treasuries to yields more than Treasuries in November 2007. That might have been a good time to enter the class, but with all the credit crisis mess going on at that time, we were not prepared to recommend taking that risk.

As of the end of March 2008, according to the National Association of Real Estate Investment Trusts, REITs yielded 4.99%. That was 1.48% more than 10-year Treasuries, which yielded 3.51% at that time. The spread is not as large today in late April, but is more in the range of 0.75%.

Remember that Treasury yeilds have been driven down by a flight to quality and to liquidity during the CDO and other credit markets crisis we are still enduring. As the crisis subsides and inflation becomes a bigger worry, Treasury yields may rise. REITs will need to follow with more distribution or lower share prices, if they are to hold their yield spread position.

There is never a perfect time to enter a market, but we have begun to feel that equity REITs make sense again, with the caveat that the financial markets are in great turmoil right now. Any recommendation is a short-term credibility risk for any analyst or advisor. Long-term, though, we think REITs make sense again.

The 20-year average month-end yield spread has been that REITs yielded 0.75% more than 10-year Treasuries, and the 10-year average yield for REITs was 1.23% more than Treasuries.

Clearly, REIT yields oscillate around Treasury yields. In a future article, we will explore the relationship of REIT yields to the S&P 500 yield.

There were some huge spreads in the 1970’s and 1980’s. That’s because there were some huge events back then. The question today might be whether the events unfolding now in the credit markets, energy markets, for inflation (real inflation, not the managed CPI put out by the government) and geopolitically, are more or less significant. If they are less significant, then valuation for REITs looks reasonable. If the current events are more significant, then the long-term past suggests we might see more major valuation swings.

REITs Yield > 1% More Than Treasuries (Nov 1973 - Dec 1975):

In the 1974 - 1975 range, we were at the end of a period of government ordered wage freeze (1972-1974). The Vietnam War was ending unfavorably for the U.S. in 1973. The Arab Oil Embargo began in October 1973 and changed perceptions about energy risk, as long lines formed at gasoline filling stations. Wage controls ended and President Nixon resigned in 1974. During 1974-1975, we saw the New York City financial crisis with possible bankruptcy concerns, and the issue of 13% tax-exempt Big Mac muni bonds. The S&P and Dow were deeply down and in a blue funk.

REITs Yield >1% Less Than Treasuries (July 1978-Mar 1986):

Paul Volcker becomes Chairman of the Federal Reserve (1979). Iran violates US Embassy in Tehran and holds Americans hostage. Gold tops at $850 (after bottoming at $104 in 1976). Hunt brothers create Silver crisis attempting to corner world market. The Iran-Iraq war begins in 1980 with prospective oil supply consequences. Spot oil tops $40 per barrel in 1980 for the first time (believe it or not, that was a shockingly high number then). Short-term Treasuries top 16% in 1981. Unemployment hits postwar high in 1982. Continental Illinois fails with a run on the bank in 1984. US Dollar sets a high against the Deutsche Mark and British Pound in 1985. The G-5 sets the Dollar Reduction Pact (yes, the opposite the G-7 plan today to rescue the Dollar). Oil prices falls below $7 per barrel. Interest rates reach 18-year low 1986.

Next:

If 10-year Treasury yields don’t shoot up next, or if REITs maintain a reasonable spread if Treasury yields do rise, REITs could be a reasonable investment now. If today is not as bad as the years before 1986, you might look into equity REITS as a separate class (note that they are in the S&P 500 for about a 2% weight).

REIT ETFs:

Some representative ETFs investing broadly in US equity REITs are:

VNQ, ICF, IYR, FTY, and RWR.

We have a full REIT allocation in our portfolios at this time, using VNQ.

Comments

[cranky old investor]

the failure of this analysis is that it looks at reits without looking at the future earning power of their underlying assets; many reit classes - retail, lodging, office - may suffer stagnation of retail revenues and an erosion of earnings in markets which are overbuilt. there are multiple trends which show, for example, that the retail real estate portfolio of the US economy exceeds the true demand for retail space by over 15 percent. Consolidation among retailers along with tied-to-sales rents can keep even the strongest mall operators from achieving any sort of growth; the 2nd tier will undoubtedly be forced to cut dividends as the coverage ratios move into danger zones.

Betting on reits means betting on the health of the US economy when the real visibility is murky, at best.

[dumbo]

Where can an individual (small) investor get the data for REIT yields in order to implement this strategy on their own? Is there, for example, an index for this, as there is for the Treasury yield?

[Seafarer]

I like health care REITs at this point in time, despite the fact that they’re trading at a 22% premium vis-à-vis the 12% average equity REIT discount. With an average 5.3% yield that sure beats the 3.7% 10-year Treasury. As the boomers age demand will climb for seniors’ residences, assisted-living facilities and nursing homes. Of course there are risks. Uncle Sam may cut back on Medicare and Medicaid nursing home funding, especially if the Democrats are elected. States medical expenditures may also be slashed as states see more red ink going forward. Although the current economic downturn may already be priced into health care REIT NAVs, lessening the opportunity for cap gains, but as a relatively safe place to make an excellent yield they sure are appealing.

[Richard Shaw]

dumbo (your handle and not my opinion),

you can find the REIT data athttp:// nareit.com/library/index.cfm

[Richard Shaw]

cranky old investor (your handle and not my opinion)

you are correct that the analysis is not forward looking, although it does state that if events deteriorate so will the investment opportunity. it also does not assert to be a comprehensive analysis and specifically states that more is to follow. "failure" is a bit harsh as a judgement, although you are correct that not all factors have been given full weight. the article analyzes one dimension only and the headline indicates that. if it were meant to be a full multi-dimensional analysis, it would have said so and would have been much longer. add what it provides to your own thoughts and other important dimensions to come up with your own decision, which you appear to have done. thanks for commenting.

[dumbo]

Thanks, Rick. I was actually hoping for a symbol whose data I could download from, say, Yahoo finance. Yahoo lists a number of FTSE NAREIT symbols (see finance.yahoo.com/lookup?s=nareit ) and I am not sure which one is for Equity REIT yields. Is it ^FNER, or some other?

[buyitcheap]

Yields will shoot up, or ought to, we need to increase rates to take the speculation out of these commodities. Otherwise, we should all go long farming.

[Richard Shaw]

dumbo --

I prefer not to rely on secondary services for data, such as Yahoo, when the primary source is available. The primary source will generally offer more raw data elements, and perhaps for longer historical periods. I am not aware one way or the other about NAREIT data from Yahoo.

The chart that stimulated your comments combined data from the US Federal Reserve and FTSE/NAREIT, and was derived from a series of spreadsheet calculations on that data. I doubt any ready free source is available that would directly give you the spread information in that chart.

If you want to use market data going forward and for short historical periods, it might be just as effective to follow one of the REIT ETFs that are based on an index such as:

VNQ
MSCI US REIT Index

RWR and IYR
The DJ Wilshire REIT index

FTY
FTSE NAREIT Real Estate 50 Index

FRI
S&P Composite REIT index

[Richard Shaw]

buyitcheap --

you are correct that rising rates due to inflation or less of a flight to quality and liquidity in Treasuries could pose a real yield spread challenge to equity REITs

[dumbo]

>>I doubt any ready free source is available that would directly give you the spread information in that chart. <<
While that may be true, my experience is that most of what can be done in Excel I can also do in my trading software using appropriate methodology. But one needs the native price series as a start. Oh, and it doesn't have to be free; I only used Yahoo as an example as its widely known; I would have extrapolated the Yahoo symbol for my data provider.

>>If you want to use market data going forward and for short historical periods, it might be just as effective to follow one of the REIT ETFs that are based on an index...<<
The problem with using ETFs as index substitutes is:
- one doesn't know how closely they track the underlying index ("tracking error")
- ETFs are realtively new so even the oldest one doesn't have a long history
- they often pay dividends that distort the price series, making calculations unreliable

My idea was that if I had the index symbol and its data from a data vendor or Yahoo, then I could backtest the hypothesis for myself and perhaps play around with the variables (I am a systematic trader).

If you do happen to become aware of the appropriate symbol(s), do post them for the benefit of folks like me. Thank you.