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.