Over the course of my career analyzing companies and markets as well as managing investment portfolios, I have been very careful to avoid the use of the words/phrase "bubble", "it's different this time" and the currently popular "new normal". While there have indeed been speculative bubbles, not all price increases reflect "bubble" status. Similarly, "it's different this time" usually implies that history has not been adequately studied. Finally, the "new normal" may reflect new levels of a business/economic cycle, and these levels may be normal for such a period, but "new normal" to describe a structural change is somewhat of a paradox.
I have recently heard of REIT dividend yields (well, many yields across sectors) being described as a "new normal" state. The paradox befuddles me and causes me to scratch my head. Speaking specifically about REITs and their dividend yields, the "new normal" may be appealing to investors who are trying to describe the low absolute yield of this asset class. A look at the history of dividend yields is in order (source: NAREIT):
As the above graph shows, REIT dividend yields are at their lowest point since the beginning of the NAREIT data series. In and of itself, this might appear to be a "new normal" dividend yield level. It might appear to be, but it is not.
Consider that dividend yields reflect the economic/financial environment in which they occur. If we accept this statement as true, then the general level of interest rates should also reflect this environment. For our purpose, let's look at the ten year constant maturity treasury (CMT) rate (source: FRB St. Louis):
As we can see from the above chart, dividend yields and the ten year CMT are directionally consistent. This can also be shown in the following chart:
It should be noted that I have changed the time period of the charts to begin in 1990, as that would be around the time that REITs began to go public and, in my opinion, better represents public REIT dividend yields.
From the chart above, we can see that REIT dividend yields do indeed move directionally with the ten year CMT rate. In fact, the correlation between the two rates over this time period is 72%, which shows a strong correlation between the two data series. The average difference between the ten year CMT and the FTSE NAREIT All Equity REIT index's dividend yield is 106bps (1.06%) and the difference is currently 168bps (1.68%). When taken together, we can see that the current low dividend yields are not surprising, they are not new, and they are rather normal.
The above chart also shows something interesting, namely, there are periods when the two rate series diverge, and may diverge significantly. The reason for this is rather straightforward - REITs rely on external financing for debt repayment and capital raising as they, by law, have to pay out 90% or more of their taxable income. In other words, REITs cannot retain sufficient cash to repay debt or engage in property acquisitions so they must access the capital markets. In the chart above, we can see that the divergences take place in times of financial stress.
- Recall that in 1998 Long Term Capital Management blew up and the Soviet Union collapsed (resulting in a debt default). The capital markets (notably the debt capital markets) locked up and raising capital became extremely difficult and expensive.
- This was quickly followed by the collapse of the speculative technology bubble which, again, hindered access to capital.
- We then see a period of strong investment in the REIT sector combined with gradually falling interest rates where REIT dividend yield were actually lower than the ten year CMT, which was quickly followed by the real estate implosion and a quick and brutal sell off in REIT shares combined with an inability to access the capital markets.
If we accept this as true, we should see a directional relationship between dividend yields and financial stress. To measure this, I used the St. Louis Financial Stress Index (description here). The relationship, expressed graphically is:
As the above chart evidences, when there is financial stress in the system, REIT dividend yields will increase and when the financial stress on the system is benign, REIT dividend yields will decrease (or, more appropriately, return to following and being correlated with rates rather than financial stress).
Bottom Line: The low absolute levels of the dividend yields available to REIT investors should not be a surprise - they are following their normal pattern. The only thing new about this is they are at a new level for the cycle. I would put forth the supposition that there is nothing new here and that current yields are normal. Many investors believe that there is a "bubble" in the Treasury market (which I also refuted here), which could then be extrapolated to the yield available to REIT investors, but in my opinion, that is neither here nor there as it is the environment we find ourselves in and have to contend with. One conclusion we can draw from this is also that when rates rise, yields will rise which will be paid for by FFO growth or a share price reduction (I would suggest the latter).
Additional disclosure: This article is for informational purposes only, it is not a recommendation to buy or sell any security and is strictly the opinion of Rubicon Associates LLC. Every investor is strongly encouraged to do their own research prior to investing.