In our judgment, equity REITs are still significantly overvalued as a group and should be avoided.
REITs have been showing some life lately. It’s tempting to participate. We are regularly asked if the time to buy is now. We aren’t market timers, but we do bide our time based on fundamental valuation.
On both a long-term and intermediate-term basis REITs are too expensive if you rely on the relationship of yield to total return. That’s what we do, which means that we are still on the sidelines.
First, a momentum case for investing in REITs now. Short-term charts of the key REIT index ETFs (IYR, RWR, ICF, and VNQ) have shown signs they may have stopped going down and are showing signs of going up. That’s what an investor might say looking at the price chart below:
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However, it is a bit harder to be so comfortable with that conclusion looking at a longer-term chart like this one:
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That’s the chart perspective, but what about the more fundamental relative yield perspective?
A long-term view of equity REIT yield return, price return and T-Bond yield tells a different story.
Based on this chart covering more than 30 years, it appears that REITs are still in an historically overvalued position.
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The blue line is the 3-year moving average PRICE return of all equity REITs. The orange line is the 3-yr moving average YIELD return of all equity REITs. The red line is the 3-year moving average 10-year Treasury bond yield.
If you can accept that yield is a good long-term indicator of value for real estate (note that yield represents almost all of REIT income, because REITs must payout 90% of more of their income), then we see that REITs go through periods of significant overvaluation and undervaluation.
The blue REIT price return line was recently in the most overvalued position relative to yield than at any time since 1974. Even now, after significant price declines (the bull argument), the blue price return line remains well in cyclic high valuation territory.
Then there is the matter of equity REIT yield relative to 10-year Treasury bonds. Not since November 1990, has the Treasury yield been greater than the equity REIT yield until we reach 2006. That’s a long time and that means it probably is an important fact to heed.
There was an eight year period from 1978 – 1986 where the REITs yielded less than Treasuries and again for three years in 1987- 1990.
Since REITs have yielded less than the 10-year Treasury only about 1/3 of the time, and that being a long time ago, we think prudence would dictate waiting for equity REITs to yield more than 10-year Treasuries once again, and for the equity REIT moving average price return to fall further relative to REIT yield.
The price return to yield return relationship can be “corrected” by a series of low price return years or a shorter period of price declines.
Richard Shaw
QVM Group LLC
Disclosure: Author does not own any equity REITs at this time.
Ealier related articles:
August 2007 35 Year of REIT to Treasury Yields
January 2007 REITs Likely to Revert to Mean Return