Change may come slowly, almost imperceptibly to the capital markets. Or it may come as a thunderbolt from the blue. But invariably it comes, raising questions and sidetracking long-running expectations in the process.
What’s unfolding presently in one corner of the marketplace appears to be change in its more subtle hue. That leaves room for debate, although it spurs questions too. Reading the trail left by the major asset classes shows that REITs are at the head of the shifting financial winds. Posting the only loss so far this year among our list of broadly defined markets, real estate securities are testing a concept that has long eluded the sector: loss.
As our table below shows, red ink distinguishes the asset class so far this year:

To find a calendar year in which REITs generally suffered a loss one has to return to 1999, when Wilshire REIT’s total return was a negative 2.6%. Since then, REITs have been on a bull market run that’s extraordinary for its duration and magnitude. If you had the prescience to buy the Wilshire REIT at the close of 1999, the resulting annualized total return from that point through this past May was a stellar 22.3% vs. a paltry 2.2% for the S&P 500, according to Morningstar Principia software.
The question is whether the REIT train has finally run its course? No one knows, but there are several reasons to consider the possibility. We can start with the observation that nothing goes up forever. REITs have taken flight now for seven years straight through the end of 2006. We don’t know if fate will make that eight in a row, but after such a long bull run, the odds of extending a rally with ancient origins looks decidedly lower the longer the party goes on.

Another reason to consider taking at least some modest profits from REITs comes by looking at interest rates. The yield on the 10-year Treasury has for some time exceeded what’s available in REITs generally. Vanguard REIT Index Fund, for instance, had a 3.65% yield on May 31–or 124 basis points below the 10-year Treasury at the time. For those who look to REITs for yield–and many do–why give up yield in return for higher risk? Presumably one could answer that the growth prospects of REITs are still high enough to overcome the yield deficit. Many subscribe to this forecast, but it rings a bit hollow to our ears after hearing for so many years that REITs are attractive because the yield offered a premium over Treasuries.
And while the 10-year’s yield has pulled back from its spike of last week, there is a growing expectation that interest rates may be headed higher still in the second half of this year. If so, that’s hardly good news for bonds or REITs.
REITs have long been thought of as interest-rate sensitive securities. As such, it came as no shock to see REITs in a bull market in years past amid a climate of falling interest rates overall. If rates move higher, REITs may be fated to suffer.
Meanwhile, there are reports of late that lenders are becoming increasingly anxious when it comes to commercial property. Does that imply a peak for buyout deals, which could have repercussions for REIT sentiment? A Reuters article today suggests as much.
Full disclosure: your editor has become increasingly cautious on the prospects for REITs in recent years. For as long as he’s embraced the view, he’s been wrong. Eventually we’ll get it right, although there’s no guarantee as to when. Meanwhile, even a broken clock offers an accurate reading twice a day.
Nonetheless, ours is a strategy of evolution, informed by the past with an eye on the future. Paring back REIT allocations, gradually but consistently, in search of greener pastures elsewhere appeals to our sense of prudence at this point in the cycle. Defense over offense is increasingly our motto when it comes to portfolio strategy. Having ridden the wave up since 2002, we have no intention of getting pulled out to sea when the tide shifts.