April 11, 2006
REIT RISK: HOW MUCH IS TOO MUCH?
Finance theory counsels that riskier asset classes carry greater volatility in their prices, a profile that necessarily spills over into returns as well. Stocks are more volatile than bonds, to cite the obvious example, and so the former tend to deliver higher returns compared with the latter over time. Unfortunately, finance theory doesn't tell us what to do, if anything, when and if those relationships are thrown out of whack. That's where common sense and the survival instinct fill in the gap.
Indeed, some of the volatility relationships these days may be deviating from terrain that some might recognize as typical. Nowhere does the atypical stand out more so than in the world of real estate investment trusts relative to the competing asset classes, as the following chart reveals.
In particular, the volatility for REITs leads the other major asset classes. (Volatility here is measured by the trailing 36-month standard deviation of monthly returns through March 2006.) Higher volatility implies higher risks. The question is whether REITs are deserving of their top-of-the-hill status as the most volatile asset class?
There are no absolutes for answering such matters, although one could make an argument that better candidates for the top volatility spot, using history as a guide, are commodities, emerging markets stocks and high-yield bonds. REITs, by contrast, are a fairly stable lot and not necessarily deserving of the current label. Some might even argue that REITs really aren't a high-risk asset class at all. Perhaps, although you wouldn't know it by look at REITs these days.
It's worth considering that the driver of the relatively high volatility in REITs is related to the fact that the asset class has been in a bull market for some time. To be precise, you have to go back to 1999 to find calendar-year red ink for the Dow Jones Wilshire REIT Index. In every year since, REITs have taken wing. And so far this year, the party rolls on, with the index up by 10% in 2006 as of yesterday's close.
In fact, the DJ Wilshire REIT Index boasts an impressive annualized total return of 23% for the five years through the end of last month, according to Morningstar. That's a universe or two above the annualized 4.0% gain for the S&P 500 over that stretch.
REITs compare quite favorably even next to small-cap stocks, which have been enjoying their own soaring bull market of late, a run that some analysts say is also living on borrowed time. Nonetheless, the Russell 2000's 12.6% annualized total return for the five years through last month still pales next to the 23% logged on behalf of DJ Wilshire REIT. What's more, not even the extraordinary 20.3% dollar-based annualized total return for the MSCI Emerging Markets Index for last five years has kept pace with REITs.
To say that REITs are due for a correction seems to understate the obvious. But the obvious isn't necessarily imminent. Still, as asset classes go, the trailing performance of REITs stands as one of the longer and stronger bull runs in recent memory. Quite simply, it's rare for an asset class to deliver such stellar returns, so consistently, for so long.
A correction may or may not be coming, but it's a subject that's become topical nonetheless. "This has been the most hotly debated topic in REITland for the past several years," observes Barry Vinocur, editor of Realty Stock Review and REIT Wrap. "And REITs are in the midst of their fifth major correction since spring 2004, partly as a result of valuation concerns, and partly because of the recent back-up in rates."
Of course, there's a risk in getting too cute in trying to call the top of the REIT market, or any other market for that matter, as history likes to remind. More than a few have tried, and so far all have failed. Predicting the end was at hand, only to learn differently, has come at a price over the years. Each and every time the correction was assumed to be the start of something bigger, REITs surprised by springing back to life. In January 2005, for instance, the end looked imminent, with the DJ Wilshire REIT shedding nearly 9% for the month. As it turned out, it was only a temporary setback in an otherwise rolling bull market.
REIT bulls have been eager to point out that the relatively high yields here have kept the asset class hot in an era when interest rates are otherwise low and less than satisfying. True enough. The 10-year Treasury yield has been inclined to stay flat in recent years, much to the chagrin of the Federal Reserve and to the relative benefit of the yield-rich REIT market.
But there's reason to wonder if that argument will now stumble, if not collapse entirely if the recent jump in long rates has legs. In relative terms, the pressure appears to be growing. As Michael Krause of AltaVista Independent Research reports in his firm's latest issue of ETF Advisor, the 4.5% dividend yield on the average REIT is the lowest in 35 years, courtesy of data from the National Association of Real Estate Investment Trusts.
Yes, the iShares Dow Jones U.S. Real Estate Index Fund (IYR) has a slightly higher yield, although REIT yields are even lower than it appears, Krause continues. He writes that "an increasing portion of IYR’s yield comes not from dividends but from a return of capital to shareholders."
Fortunately for investors, capital gains thrown off by property have been strong in recent years. But what if the stream of capital gains in the future isn't quite what it's been in the past? And while we're reviewing what may not happen, consider too that dividend income from REITs doesn't qualify for the lower tax rate on dividends enacted by Congress in 2003, Krause adds. "Because REITs themselves are tax exempt, if they pass most of their income through to shareholders, dividends received by shareholders are taxed at the shareholder’s tax rate on ordinary income—as high as 35% on Federal taxes alone."
But wait--there's more (or less, as he suggests). Krause also notes that IYR's fund expenses are deducted from dividends received prior to arrival in shareholders' accounts. "That’s true of all funds, but where yield is the primary focus of investors it’s particularly important."
When you add it all up (or subtract it all out), REIT yields may be lower than you think, Krause concludes. That by itself may not be enough to generate the tipping point, a la Gladwell. But REITs don't live in a vacuum, in case you didn't notice.
Yields found elsewhere may be heading higher, at least relative to what the fixed-income set was recently expecting. The yield on the benchmark 10-year Treasury Note continues to hold at just under 5.0%--the highest in nearly four years.
REITs may nonetheless prove resilient one more time. But circumventing fate surely will get tougher if bond yields continue rising. Competition, presumably, still counts for something in the 21st century. Exactly what remains to be seen.
© 2006 by James Picerno. All rights reserved.
Posted by jp at April 11, 2006 10:22 PM
I'm a big fan of Reits and BDC. They are perfect investments for taxable accounts. The current REIT etf's all focus on equity reits that own real property.
They don't give exposure to mortgage REITs which is where a lot of value is these days. Not all mortage reit's are getting crunched by the flattening yield curve and many have transfered the yield curve risk via securitizations and hedging.
Also a related reason for REITs to increase in price has to do with REITs as an inflation hedge, just like gold.
Posted by: Market Participant at April 13, 2006 1:22 PM
I look at REITs (and other asset classes) in two ways: normal asset allocation, and short-run (1 year out) likely return. Real estate should be in all portfolios. Most individual investors have plenty in their home(s), but a few are very stock-heavy in their investments. REITs are an easy way to add real estate to a portfolio. For individuals, IRAs are a good holding container for REITs, especially if the IRA is large thanks to a 401(k) or pension rollover. REITs would also be good for smaller institutional accounts, which have a hard time owning real estate more directly.
However, the short-run outlook scares the bejeesus out of me. Too many investors are focused on the rear view mirror. REITs have never had much appreciation during rising long rates, and their current payouts are nearly as great as they were a few years ago. I'd encourage go light on the allocation to REITs at this time.
Posted by: Bill Conerly at April 11, 2006 2:40 PM
Both good comments. I'd add in the fact that volatility is not "risk", at least not to me it's not. Risk to me is either permanently losing money, as in buying a stock that goes down and doesn't come back, or underperforming in terms of my prtfolio not appeciating to a level sufficient for me to retire with the income I want (assuming my expectations are reasonable). Volatility means very little to me.
That being said, I've lightened up quite a bit on REITs recently because their yields have come down a lot, and I had gains in them in the past two years that I thought it'd take me 5-6 years to get.
Posted by: Eye Doc at April 11, 2006 9:44 AM
Another point about REIT dividends:
Yes, it’s true that REITs don’t qualify per se for the lower tax on dividends. But (1) they already get favorable treatment and (2) what Krause totally misses is that a number of studies have shown that a significant portion of REIT dividends do, in fact, qualify for the dividend tax break by virtue of the fact that dividend income generated by so-called taxable REIT subsidiaries (TRS) does qualify. (Both Cohen & Steers and NAREIT have looked at this issue, as well as others.) This obviously will vary year-to-year, but recent studies suggests it’s north of one-third of REIT dividends.
Finally, it’s important not to lose sight of the fact that (1) for investors who hold REITs in tax-advantaged accounts (as almost all investors should) this discussion is entirely irrelevant because they don’t pay tax on those dividends and (2) tax-exempt institutions also aren’t paying taxes. Go back to before the tax bill was passed that cut taxes on dividends – sell-siders hung crepe all over the place because of the change. REITs would get hammered, they warned. Wrong, wrong, wrong. Said differently, it’s true, but so what?
Posted by: Barry Vinocur at April 11, 2006 8:27 AM
Yes, REIT volatility has gone up. However, one reason REITs look so much more volatile than, say, the S&P 500 is that S&P 500 volatility has dropped significantly in recent years. (MSCI has published on this.) Bottom line, the combination of the two distorts reality.
Second, there's no way that an asset class such as REITs can mature and as part of that process be included in major (and minor benchmarks), such as the S&P 500 (11 REITs have joined the S&P 500 just since October 2001) and things not change. Look at REIT liquidity; it's much higher today than back in early 2001, before REITs were approved for inclusion in S&P's indices. It's like looking at one of your kids and saying, "Gee, I sure miss the way he/she was when he/she was five."
Meanwhile, the dividend argument is just goofy. REIT prices go up, dividend yields fall. Nevertheless, while REIT yields (currently at around 4.2%) are lower than the yield on the 10-year, so what? REITs are currently priced to deliver roughly 9%; you ain't getting' that from a 10-year, are you?
Also, REIT dividend growth will accelerate as NOIs start ramping up, which they are now doing. Will REITs get back to the 7% yield days? Were that to happen in the near-term, the pain would be huge.
In a lower-return world, REITs are priced to deliver a rate of return in between equities and bonds.
Plus, correlations remain low, so they still provide that all important diversification.
Finally, IYR is a horrible ETF to look at. We have written endlessly on this; however, briefly, IYR is being used by macro hedgies and others for reasons totally unrelated to their views on REITs/real estate (e.g., volatility trade, as well as interest rate trades, etc.).
Heck, look at what's in IYR. It has REITs, but it also has a lot of stuff that no self-respecting REIT portfolio manager would buy. Far better ETFs to look at are ICF, RWR, or even VNQ -- which is the ETF version of the Vanguard REIT Index Fund.
Moreover, underscoring how goofy IYR is, look at how it trades (e.g., volume is through the roof for a REIT ETF, and just since March 28, $715.2 million has been yanked out of IYR). In REITland, $715.2MM over that short a time period is still a HUGE number.
Posted by: Barry Vinocur at April 11, 2006 8:22 AM