In the coal mine, the demise of the canary sends an early warning sign that’s something amiss in the atmosphere down under. Might REITs be the proverbial canary in the financial market warning that the investment air isn’t quite fit to breath at current valuations?
To judge by one REIT of late there’s certainly reason to ask if the much-discussed and, for some, much-anticipated correction in real estate and related securities has arrived in earnest. True, REITs have corrected several times previously in the 21st century, sometimes dramatically, only to recover and put a considerable amount of jam on the pessimists’ faces. But how many lives does the REIT sector have?
In pondering that imponderable it slipped by no one who follows REITs that Annaly Mortgage Management last week collapsed its dividend to 13 cents from 36 cents. The news had the expected effect on the company’s stock, which promptly dropped like a rock after the press release made the rounds.
The challenge for Annaly, and others who turn a profit from a positively sloped yield curve, is a world where borrowing short and lending long is fast going the way of the dodo and the SUV. Indeed, the latest installment of that reality came knocking again yesterday when the Federal Reserve raised short rates by 25 basis points for the 11th consecutive time while the 10-year Treasury yield barely budged.
Even before the latest hike in Fed funds, the writing has been on the wall, even at Annaly. “As students of our business model are aware, during the tightening phase of an interest rate cycle our cost of financing will rise faster than the yield on our assets,” said Michael A.J. Farrell, chairman, CEO and President of Annaly explained to stunned shareholders last week.
Welcome to life in a financial universe dominated by a flattening yield curve. To be sure, the narrowing of the spread between long and short rates is no sudden development. But with Fed funds now at 3.75%, or less than 50 basis points below the 10-year Treasury (and less than 25 basis points below the five year Note!), the recognition that there’s no traction in turning a profit from yield-curve plays is sinking in to Mr. Market’s noggin.
There’s a temptation to distinguish between mortgage REITs and those that focus on properties. Annaly, after all, is essentially a financial shop whereas property REITs own and manage offices, apartments, shopping centers, and so on. Two different worlds, right? Absolutely, with different business models to prove it. Nonetheless, property REITs generally aren’t faring all that well these days either. The Dow Jones REIT Index, for example, fell again today, as it has for much of this month. The highs that REIT benchmarks were setting in the summer suddenly seem like ancient history.
Even if investors decide to return to REITs, as they’ve done time and time again in recent years after corrections, expectations about the sector may still be in need of an attitude adjustment. In turn, that suggests that heightened volatility in REIT prices may be par for the course from here on out. “It’s harder for all of us to produce the numbers we were able to in the past,” Michael Fascitelli, president of Vornado Realty Trust, tells Commercial Property News today. The sector’s enjoyed strong growth in recent years, but as the history of corporate America suggests, maintaining growth rates becomes increasingly difficult as businesses grow. “People expect more,” Fascitelli concludes.
Alas, investors may have to settle for less. REIT prices have been climbing for much of the 21st century. Even the stock market’s undoing after the bursting of the tech bubble didn’t derail the mighty REIT train. And for good reason, when everyone expected interest rates would continue to fall. The white knight was the world of REITs, which generally offer some of the highest equity yields in the marketplace. But yields just aren’t what the used to be. Vornado, for instance, carries a 12-month trailing yield of around 3.5%, according to Bloomberg. As of yesterday, that’s comfortably below Fed funds, and by extension, more than a few short-term debt instruments.
True, there are higher yielding REITs out there, including the 6%-plus on Equity Office Properties, the largest U.S. REIT. But the competition is rising. And as Annaly’s latest announcement suggests, more dividend cuts may be coming.