The main argument for owning REITs is that they provide greater income than bonds while providing an inflation hedge, much like TIPS (inflation protected bonds). The main issue for REIT holders isn't the economy and it isn't ten-year bond yields, it's the rise of the ultra-safe 2-year note yield:
Now, I do think that the 2-year note is a much better buy than most REITs and also I think it's a better value at these levels than the ten-year treasury bond. In any case, that value proposition essentially means the "Risk-Free Rate" (if there is such a thing) has gone from around .5% to 2.1% in a year and a half. That, folks, materially changes investor future free cash flow calculations when discounted back to the Net Present Value. The Risk-Free Rate was basically zero for the past five years, which meant making money in equities was as easy as hiring a (preferably lucky) monkey to throw darts at the Wall Street Journal's investment section to pick your long holdings.
The Indexing Revolution is a reflection of the Risk-Free Rate being close to zero in my view. A rising tide lifts all boats. It was a good idea to fire all of those Harvard and Oxford graduates because they simply couldn't beat the market, and therefore didn't deserve their management fees. Investment ignorance has been bliss for a decade now, and guys discounting future free cash flows by the Risk-Free Rate were simply no match for randomly selected outcomes. Part of this conundrum was self-fulfilling: MBAs and CFAs are all taught that markets are efficient and cannot be "beaten." The best minds at Treasury and the Fed then also believe that the price of the market is "always right" because fundamental analysis in itself is speculative - the "market is the market" and the price is always a precise and efficient representation of value. In short, the monkeys are always right:
You see, evaluating REITs cannot be done successfully without getting into the mind of the Fed, which has pumped massive liquidity into the system (creating what Janet Yellen swears is not a bubble; let's hope she's correct) and has held long-term rates down with QE and operation twist.
With the Federal Reserve and the Congress so intent on making equity valuations great again, investing in REITs must be done with the full mindfulness of the historical context of the rally. Over the past year, the curve has flattened a bit, but this is no reason to panic-buy or panic-sell anything. Rebalancing after such a huge rally makes sense.
Those looking for income have been starved by a very low rate of interest, and many have been pushed into dividend equities, REITs, and high yield bonds (HYG) because of income requirements. "Stocks are the new bonds" is what many investors have been sold - and this has caused yield-seeking behavior among retirees who can't afford a bear market. The latest episode in stock market might just reflect smart money retirees rebalancing or rotating into shorter term bonds.
What worries me is not necessarily the valuations on REITs like IYR, which are reasonable enough, trading for a 5% or so FFO yield, but the capital flows if bond yields were to continue rising or if the stock market continues its healthy correction. In my view, a falling equity market will hold yields in check. After a big enough drop in the stock market, I would expect easier monetary policy. If that occurs and yields fall due to QE, one would expect a REIT ETF paying 5 or 6% to be one of the better investment alternatives around. At current levels, holders of these securities are between a rock and a hard place. Inflation could help, and so could a stronger economy. The risk of a continued slump is very real, however, unless Jerome Powell goes full Kuroda.
If you are looking to buy REITs, I would stick with a low-cost ETF like the Vanguard REIT Index (VNQ). The September 21, 2018, $80 put option sells for just $4.20 per contract. With the price of the shares at $77.11 currently, this married put set-up looks quite attractive. Your downside is capped at around 2.5% and your upside is nearly unlimited. The dividend yield will essentially pay for your hedge. This trade to me seems like a bulletproof enough investment idea, provided you can calmly assess the risk/reward skew and don't have to chase the overall rally in stocks.
Disclosure: I/we 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.