Equity REITs Not Yet At Fair Value
In January of this year, we wrote that equity REITs were overvalued on the basis of yield and that they would likely decline by reverting to their mean yield. About then, the REIT market turned down – about 15-16% so far. However, that is not enough to restore fair value. We believe that REITs must surrender another 1/3 to 1/2 of their market price to be fairly valued relative to 10-year Treasury bonds
The chart below shows the abrupt turn in market action for the group in the January-February time frame.
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As with any mania, momentum becomes the sole focus at the expense of fundamentals. At some point, the market runs out of gullible souls, the momentum stops and then reverses. It’s been a downward slide since then, but there is far yet to go.
In the long run, real estate is a yield oriented asset. It cannot appreciate forever beyond certain relationships of its yield to market interest rates. Interest rates act as a sort of center of gravity for REITs in the long run.
In the past couple of years, REIT investors had forgotten about that orbital relationship between real estate yields and bond yields. Now the sector is paying the price of prior excess enthusiasm with a declining market.
The pain will not likely stop here. We estimate that the equity REIT sector has far further to decline to restore a rational and historical relationship to Treasury yields. That likely decline is an example of “reversion to the meanâ€, a powerful force acting on securities markets.
Consider this table that compares the average equity REIT yield with the average 10-yr Treasury bond yield for 7 prior years and 7 prior months of this year.
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You can see that in the four years of 2000 through 2003, equity REITs provided a yield that was about 150 to 240 basis points above 10-yr Treasuries. However, that positive yield spread broke down in 2004 and then became negative in 2006, where it is still today.
The positive yield spreads of 2000 to 2003 make sense to us. To restore those spreads one or a combination of these things must happen:
- REIT prices decline
- Intermediate-term interest rates decline
- REIT cash flows increase.
If we were to expect all of the change to come from REIT price declines, those declines would have to be in the 33% to 50% range.
There are four principal domestic equity REIT exchange traded funds worth considering when the time is right, and that time is not now. The right time is when the yield spread is at least positive 100 basis points, and preferably more.
The key ETFs are from Vanguard (VNQ), Barclays (IYR), State Street (RWR) and Cohen & Steers (ICF).
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We like VNQ the best. They have the lowest expense ratio, the most diversified portfolio, and the largest asset pool. They are not as actively traded as the Barclays, however, but we expect volumes to increase over time. Vanguard came to the game late and its ETFs are still catching up with Barclays and State Street in terms of trading volume.
Richard Shaw
QVM Group LLC
disclosure: author does not own any mentioned security