What's The Right REIT Move Now?

| About: iShares U.S. (IYR)

"Our greatest glory is not in never falling, but in rising every time we fall." - Confucius

As U.S. REITs are once again in decline in the midst of rising rates and tax-loss selling, investors may wonder if the time is right to discover value at current levels.

The Recent REIT Squeeze Play

Since the peak in May 2013, the U.S. REIT market as measured by the iShares U.S. REIT Index ETF (NYSEARCA:IYR) is down 16.81%, which is a slight recovery from the peak-to-trough return from May to late August of -20.06%.

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After the market closed on October 21, 2013, I wrote the article The U.S. REIT Market: IYR Ripe For A Pullback, which supported the thesis that REITs were due to fall.

"There is an elevated risk of a short-term U.S. REIT correction due to a lower demand for U.S. Treasuries and year-end tax harvesting of capital losses."

Since the close of trading on the next available trading day, REITs have dropped 5.98% as measured by the IYR fund.

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During this same time frame, the 10-year yield rose from 2.51% to 2.883% (+37.2 basis points).

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Seeking Alpha writer Brad Thomas disagreed with my thesis however, stating on October 22 that my

"argument is without facts as he stated the 'probable risks inherent in the market that may present near-term REIT weakness, specifically within the next 30 days.'"

While tax-loss selling cannot be quantified, the relationship between the REIT market since late May 2013 has been an inverse correlation. As noted by the charts above, as the 10-year yield rose immediately following my article while the IYR showcased the inverse relationship to the 10-year by selling off.

In the current market, the rates are still trending higher and the REITs are still trending lower. Morningstar analysts recently wrote REIT Interest Rate Concerns May Be Overblown, stating on December 6, 2013 that due to interest rate concerns, the REIT market is now undervalued. Specifically, Morningstar cited interest rates rising as a less important factor to REIT performance than economic growth.

By studying the past 20 years of market performance, Morningstar concluded

"The historical evidence suggests that economic growth is more important to REIT performance than interest-rate changes."

This analysis is supported by the Thomas in his October 22 article where his analysis showcases how rising interest-rates do not historically determine aggregate REIT underperformance. With a chart that accompanies rate changes with REIT performance, Thomas concludes

"Historically, REIT returns have generally been very good when Treasury yields are up."

The Morningstar argument that REITs have not historically had an inverse relationship was also argued by Thomas on August 29, near the 52-week REIT low. That analysis, as well as the Morningstar research does not take into consideration one of the primary market drivers: market sentiment.

Further in their analysis, Morningstar warns about economic risk affecting the REITs by stating

"the U.S. economy's sluggish growth does not inspire confidence that a near-term uptick in rates would be offset by growing REIT cash flow."

Where Are REITs Today?

While off the late-August 52-week low, negative REIT sentiment and continued interest-rate fear continues to spook the sector. Research dictates that REIT returns are more inclined to follow economic growth than rising rates, however the current investor may see a double-edged sword as economic growth will only advance the taper, which in turn will likely lead to rising rates. Market sentiment remains negative however, which promotes further decline in the sector.

On a positive note, the last date to trade a security for strategic tax reasons is only a few weeks away. While U.S. investors must trade inside the calendar year to reap such tax-loss benefits, Canadian investors are required to trade earlier as their taxes are based on the year-end settlement date. For Canadians this equates to a December 24, 2013 trade date.

In terms of new REIT strength, potential consolidation of the multi-family residential apartment subsector has buoyed the sector as several reports indicated that Essex Property Trust (NYSE:ESS) bid $5 billion for BRE Properties (NYSE:BRE) on December 4, 2013.

In further good news, SNL Financial's quarterly Net Asset Value report reports that the median premium or discount on all U.S. REITs was -6.6% at the start of the current quarter. Multi-family residential REITs were the most undervalued at -14.81%, which supports the recent subsector consolidation theme.

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Morningstar also states that all U.S. REITs as undervalued, measuring the sector as trading at a 97% to fair value ratio as of December 6, 2013.

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According to SNL Financial and Morningstar, the U.S. REIT market is undervalued. Investors are left with the choice to either fight the tape and pursue value, or wait until relative strength provides increased sector support.

Morningstar research supports that REITs need economic growth to achieve growth, whereas such growth, if strong enough, will offset rising rate concerns.

The U.S. economic data released on Friday December 6, 2013 suggests a strengthening domestic economy. The November non-farm payrolls number increased 203,000 (beat estimate of 185,000), November unemployment dropped to 7.0% (from 7.3% in October) and October personal spending and consumer credit increased and expanded faster than expected.

As the U.S. REIT market has been on a downward slide since late October, the current sector sentiment remains negative. Rising rates have been prevalent in conjunction with the lowered prices, while the immeasurable tax-loss harvesting theme may also be taking a role.

In the current downturn, the economy is showing signs of strength. As such and in-line with Morningstar research, REITs may provide value on a case-by-case basis. Recent sector consolidation efforts, as well as research by SNL Financial, showcase that multi-family REITs may be an excellent starting point.

To learn more about the long-term bullish prospects on the U.S. REIT market, please read The Case For The U.S. REIT Bull Market, published on September 19, 2013.

To learn more about the dangers and specific risks of investing in a down market, please read Don't Fight The Tape: U.S. REITs In Decline, published November 26, 2013.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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