Yield Spreads Signal Buy Opportunities For REITs

by: Dane Bowler
Summary

When REITs trade at wide spreads to treasuries, it is usually a good time to buy.

The REIT index is currently trading at a normal spread, but pockets within it are looking quite cheap.

Specifically, micro cap to mid cap REITs are trading at massive spreads to treasuries.

REITs have a reasonably consistent payout ratio at an index level which makes the dividend yield an excellent proxy of value. When yields are high there is good value and when yields are low, they may be getting a bit pricey.

Over the past 5 years, when REIT yields have blown out relative to 10 year Treasury yields it has been a great buying opportunity. In the chart below, we can see that REITs typically trade at a spread of 100 to 150 basis points above the 10 year Treasury yield.

Source: SNL Financial

However, in February of 2016 REIT prices dropped materially causing REIT yields to rise while Treasury yields were falling. The spread got as high as 266 on 2/12/16 with REITs at a 4.4% yield and the Treasury at 1.74%. REITs returned about 30% in the next few months.

Another wide spread opened up in December of 2018 when REIT prices plummeted leading to a yield of 4.55% while the Treasury remained at just 2.74%. This too led to a strong REIT rally in the coming months.

As of yesterday’s close, the spread was fairly normal at 136 basis points with REITs yielding 3.76% and the 10 year yielding 2.4%. This would indicate a normal performance for REITs in the near to mid term. For REITs, a normal performance is reasonably strong as they have substantially outperformed the S&P over long stretches of time.

Thus, we believe REITs are a decent place to park one’s capital in general, and that now is a decent time to get in if one is not already in REITs.

Fundamentally, REITs are well positioned at the moment as they are more sheltered from the increased geopolitical tensions. 2 specific aspects of REITs provide layers of protection from the current global environment:

  1. REIT properties are largely domestic. While most of the large cap S&P companies do business globally, including extensive business with China through both supply chains and direct customer relationships, REITs overwhelmingly derive their revenues from the U.S.
  2. REIT cashflows are mostly contractual in nature which protects against temporary shocks in their industry verticals. Temporary events may interrupt the cashflows of REIT tenants, but usually will not impact REIT revenues.

Given these properties, along with the generally higher rate of return, REITs seem to be a good safe haven in these times of increased uncertainty.

That being said, I do not advocate for blanket purchases of REITs as there are some that are poorly run and many that are substantially overvalued. Instead, we prefer a more targeted approach, isolating the undervalued and excluding the bloated, overbought REITs.

As we discussed at the outset, blown out yield spreads are a great buy signal for REITs. While the yield spread for the entire index is normal and unexciting, there are pockets within REITs where yield spreads are fully blown out.

Small caps will generally trade at a higher yield than large caps, but normally it is somewhat close. For most of the past 5 years, small cap REITs trading within a fairly tight range above the large caps.

Source: SNL Financial

Specifically, on 5/15/2014, micro caps traded at yields of 5.46%, mid caps at 4.56%, small caps at 4.18% and large caps at 3.56%. This 60 to 200 basis point range remained consistent until late 2018 where the non-large cap REITs got unusually cheap. Take a look at the spreads as of yesterday’s close. Source: SNL Financial

Micro caps yield 7.74%, mid caps 6.24%, small caps 5.23% and large caps 3.65%.

Those 60 to 200 basis point spreads have become roughly 160 to 410 basis point spreads. I believe this is a massive buy signal for REITs ranging from micro caps to mid caps.

Not technical analysis

I understand that all of this talk of buy signals while referencing a series of charts may seem like technical analysis, but it is firmly rooted in fundamental value analysis.

Dividend yields are mathematically inversely related to market prices, so blown out yield spreads directly mean superior relative value. In other words, the blow out in yield spreads between micro-mid caps versus large caps means micro-mid cap REITs are more opportunistically priced relative to large caps than is historically normal.

Micro-mid cap REITs normally trade at a discount to large caps, and currently that discount is far larger than normal. We have been loading up on small REITs to capture outsized yields and the potential for sizable capital gains as prices return to their normal ranges.

Disclosure: This article is provided for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer. Information contained in this article is impersonal and not tailored to the investment needs of any particular person. It does not constitute a recommendation that any particular security or strategy is suitable for a specific person. Investing in publicly held securities is speculative and involves risk, including the possible loss of principal. The reader must determine whether any investment is suitable and accepts responsibility for their investment decisions. Dane Bowler is an investment advisor representative of 2MCAC, a Wisconsin registered investment advisor. Commentary may contain forward looking statements which are by definition uncertain. Actual results may differ materially from our forecasts or estimations, and 2MCAC and its affiliates cannot be held liable for the use of and reliance upon the opinions, estimates, forecasts and findings in this article. Positive comments made by others should not be construed as an endorsement of the writer’s abilities as an investment advisor representative.

Conflicts of Interest. We routinely own and trade the same securities purchased or sold for advisory clients of 2MCAC. This circumstance is communicated to clients on an ongoing basis. As fiduciaries, we prioritize our clients’ interests above those of our corporate and personal accounts to avoid conflict and adverse selection in trading these commonly held interests.

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.