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IYR - REIT Index


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What are your thoughts from a macro perspective on REITs?  I've been buying lately (just the index, nothing specific), as a relative trade (I'm already short the long bond and short S&P 500 as a hedge on portfolio).

 

From a relative value perspective, IYR index is within 3% of their dividend-adjusted 52 week low.  Meanwhile the S&P 500 is about 1% off its 52 week high, and interest rates are still very low (albeit not as low as a year ago).  Relative to to US stocks, gov bonds, and corp bonds, REITs seem cheap (again, on a relative basis).

 

Looking at the asset class on an absolute basis, it doesn't seem expensive either.  The bloomberg expected dividend yield is something around 4.3%; my calculations convert that to an equivalent unlevered cap-rate of around 5.5%.  Not terrible; add in 2% inflation and 1% real growth for an expected total return of maybe 8.5%, on an unlevered basis.  Additionally, not all of the reits are mature; there are many development properties within the REIT index; this adds additional growth.  So all in you are looking at a total expected return of high single or low double digit rates, on an unlevered basis, for the underlying properties.  Once you consider the 30% or so average leverage of the index, the expected return should be slightly higher.

 

Am I off base here?  Have I missed anything - how could this be wrong?  Again, I am not saying they are cheap on an absolute basis - only that they seem cheap on a relative basis, and not expensive on an absolute basis.

 

Thoughts?

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ARCP looks pretty cheap with a ~7.5% yield. They are single-handedly bringing the "net lease" segment out of no-man's land via aggressive, but smart acquisitions. They do have more debt than the sector average, but this is pretty easily taken care of via a few more all-equity purchases. Even at dilutive share prices, ARCP could help its own valuation profile by issuing stock at attractively-priced properties.

 

Here is the most recent merger presentation:

 

http://ir.americanrealtycapitalproperties.com/Cache/1001180496.PDF?Y=&O=PDF&D=&FID=1001180496&T=&IID=4280143

 

 

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No takers?  I'll reply to myself then...

 

While the REIT index is down almost 20% from its highs earlier this year, and down YTD, this is disconnected from almost all other assets that it should be correlated with: Underlying commercial property indices, case-shiller residential properties, & the stock market. 

 

Green Street's CPPI is still at highs:

http://www.greenstreetadvisors.com/pdf/press/cppi/GSACPPI.pdf

 

Some research on the disconnect:

http://landandbuildings.com/downloads/LB%20PUBLIC%204Q2013%20CRE%20Outlook.pdf

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ARCP looks pretty cheap with a ~7.5% yield. They are single-handedly bringing the "net lease" segment out of no-man's land via aggressive, but smart acquisitions. They do have more debt than the sector average, but this is pretty easily taken care of via a few more all-equity purchases. Even at dilutive share prices, ARCP could help its own valuation profile by issuing stock at attractively-priced properties.

 

Here is the most recent merger presentation:

 

http://ir.americanrealtycapitalproperties.com/Cache/1001180496.PDF?Y=&O=PDF&D=&FID=1001180496&T=&IID=4280143

 

we spoke about this one before.  I haven't gotten to the point of looking at individual reits, just the market as a whole seems a bit disconnected to me. 

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What are your thoughts from a macro perspective on REITs?  I've been buying lately (just the index, nothing specific), as a relative trade (I'm already short the long bond and short S&P 500 as a hedge on portfolio).

 

From a relative value perspective, IYR index is within 3% of their dividend-adjusted 52 week low.  Meanwhile the S&P 500 is about 1% off its 52 week high, and interest rates are still very low (albeit not as low as a year ago).  Relative to to US stocks, gov bonds, and corp bonds, REITs seem cheap (again, on a relative basis).

 

Looking at the asset class on an absolute basis, it doesn't seem expensive either.  The bloomberg expected dividend yield is something around 4.3%; my calculations convert that to an equivalent unlevered cap-rate of around 5.5%.  Not terrible; add in 2% inflation and 1% real growth for an expected total return of maybe 8.5%, on an unlevered basis.  Additionally, not all of the reits are mature; there are many development properties within the REIT index; this adds additional growth.  So all in you are looking at a total expected return of high single or low double digit rates, on an unlevered basis, for the underlying properties.  Once you consider the 30% or so average leverage of the index, the expected return should be slightly higher.

 

Am I off base here?  Have I missed anything - how could this be wrong?  Again, I am not saying they are cheap on an absolute basis - only that they seem cheap on a relative basis, and not expensive on an absolute basis.

 

Thoughts?

 

The expected real long term returns on REIT as an asset class historically have been a tad less (I think about 1% less) than the dividend yield. I do not have a reference but William Bernstein has written quite a bit on this if you want to look up. I am not sure why, but dividends have not been able to grow at the inflation rate historically. This is based on roughly 40 years of data from 1970s.

 

Since REIT's need to payout 90% of their income, they do not have much to invest organically to provide real growth. Any growth that they generate is by dilution - they would issue stock which would fund the growth, but it becomes a wash. All you get is the dividend which grows by about 1% less than inflation so your expected return is dividend yield + inflation - 1%. 

 

I am not sure why you want to use the Cap rate to calculate the returns. It would be the return to the REIT before all operating expenses. Cap rate is what you would earn if you invest directly in real estate and do not incur any additional expense, which is not the case with REIT structure.

 

My filter had been to look at REIT's when dividend yield starts going up above 7% which is a looong way.

 

Thanks

 

Vinod

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ARCP 7.5% at the moment :)

 

I just stick to index for REIT's as I never really took time to understand the industry. But it is an easy asset class to value that periodically provides opportunity to put a little money to work on mean reversion.

 

Vinod

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a Primer on REITs attached.

 

Thanks.  Interesting to see the sectors long-term valuation charts, but the report was as of 4/19.  REITs were 16% higher at that point.

 

If the charts were updated, I would think they would for the most part tell the same story I've pitched: REIT valuations (relative to historical levels) are more attractive than stock valuations (relative to historical levels) or bond yield-spreads-to-inflation (relative to historical levels).

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My filter had been to look at REIT's when dividend yield starts going up above 7% which is a looong way.

 

I'd be interested in seeing that long-term research you found indicating average long term real rates of return.

 

Also, if you are interested in real rates of return, why are you running your screen on an absolute rate of return?  If you compare the spread between average yields and the 10 year treasury or corporate bonds, the yields begin to look attractive (relative to long-term averages).

 

edit: I should also restate I'm interested in relative valuation, relative to historical levels and relative to other asset classes (because I have hedges on rates and stocks).  I'd be interested to get your thoughts on where you view the asset class right now on a relative basis.  thanks.

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My filter had been to look at REIT's when dividend yield starts going up above 7% which is a looong way.

 

I'd be interested in seeing that long-term research you found indicating average long term real rates of return.

 

Also, if you are interested in real rates of return, why are you running your screen on an absolute rate of return?  If you compare the spread between average yields and the 10 year treasury or corporate bonds, the yields begin to look attractive (relative to long-term averages).

 

edit: I should also restate I'm interested in relative valuation, relative to historical levels and relative to other asset classes (because I have hedges on rates and stocks).  I'd be interested to get your thoughts on where you view the asset class right now on a relative basis.  thanks.

 

I am interested in real returns (as opposed to nominal returns) which is closely approximated by the dividend yield on REIT's. The way I see it, REIT's should have a return a bit lower than that of stocks for several reasons - lower business risk, shorter duration, etc. So at fair value they should generate somewhat lower returns than stock market long term average real return of about 6.5%. For REIT's this would translate into a fair value of roughly 6% dividend yield. This is also their average yield for the past 15-20 years. I just look to buy when the yield is significantly above this average and sell when it comes back down to average. I average up buying and average down selling. So on an absolute return (as opposed to relative return) basis I think REIT's are overvalued just like stocks and bonds.

 

Since stocks, bonds and reit are all overvalued, I am just not sure why you would try to capture the spread. It looks like a lot of risk for small return.

 

William Bernstein has written lots of short articles and written about REIT's in his books. The best I can find that seems to capture most of it is below:

 

http://www.bogleheads.org/forum/viewtopic.php?f=10&t=115965

 

You must already know about the index data but here it is if you are interested. This has the historical returns and dividend yields.

 

http://www.reit.com/DataAndResearch/IndexData/FNUS-Historical-Data/Monthly-Index-Data.aspx

 

Vinod

 

 

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  • 2 weeks later...

What’s Wrong With REITs, Anyway?

 

http://blogs.wsj.com/moneybeat/2013/12/20/whats-wrong-with-reits-anyway/

 

 

 

 

Taper your expectations, real-estate investors.

 

That’s one of the clearest lessons from the Federal Reserve’s decision this Wednesday to scale back, or “taper,” its bond-buying program to $75 billion from $85 billion per month.

 

Between Wednesday morning and Friday’s close, stocks gained 2.1%. But real-estate investment trusts—the popular, publicly traded bundles of commercial, residential and other property—were up just 1.2%, with sharper bounces along the way.

 

This week’s jittery behavior by REITs is the latest scene in an eternal tragedy of investing: When too many people want to own something all at once for the wrong reasons, they will almost certainly end up sorry they bought it at all.

 

You should own REITs because you want to diversify some of the risks of stocks and bonds and to combat inflation—not because you are chasing high dividend yields or because you think the hot returns of the past will persist.

 

Until earlier this year, REITs were one of the hottest assets around: Between the beginning of 2009 and the end of 2012, the FTSE NAREIT Equity REITs Index, a broad measure of the sector’s performance, returned an average of 20.3% annually, including dividends, while U.S. stocks overall earned 14.6%.

 

“For investors who were worried by what they saw in [stocks] in 2008 but wanted to move a little beyond fixed income, there was an attractiveness to REITs,” says Wyatt Lee, manager of the T. Rowe Price Real Assets Fund, a portfolio of companies related to energy, commodities, real estate and other physical assets; the fund has more than 30% of its $3.5 billion in REITs.

 

Unlike most corporations, REITs are required by law to pay out essentially all of their net earnings as dividends. Their average yield—annual dividend divided by share price—of approximately 4% is twice the payout on stocks and one-third more than you can earn on 10-year U.S. Treasury bonds.

 

By the beginning of this year, investors weren’t just adding money to real estate; they were attacking it. In the first five months of 2013, $10.3 billion poured into real-estate funds, according to Morningstar. By the end of May a remarkable 9% of the $110.8 billion in these funds’ total assets had arrived since Jan. 1.

 

That month, the Federal Reserve began talking about tapering, which many investors regard as a prelude to rising interest rates. REITs promptly collapsed, with a 5.9% loss in May alone. This year, the S&P 500 has returned 30%; REITs have earned less than 2%, even after counting their 4% dividend.

 

Right on cue, between May and last month, many investors locked in their recent losses, yanking $2.5 billion out of real-estate funds as prices fell.

 

“As bond yields go higher, the dividend yields of REITs relative to those on bonds aren’t as attractive,” says Jeffrey Kolitch, manager of the Baron Real Estate Fund, with roughly $927 million in assets. Because REITs can’t retain their earnings to fund capital expansion, says Mr. Kolitch, they “are more susceptible to higher borrowing costs than many other companies.”

 

But it’s important to look beyond the short term, says Mike Kirby, chairman of Green Street Advisors, a real-estate research firm in Newport Beach, Calif.

 

In the long run, REITs “are not quite as interest-rate sensitive as some people think,” he says, because their earnings tend to grow as the economy improves: “REITs will probably do fine if interest-rate increases are tempered and moderate,” say a half-percentage point annually for a couple of years. They would, however, underperform stocks if interest rates jump sharply, he says.

 

After this year’s setbacks, says Mr. Kirby, “REITs are on the cheaper side of a fair range of valuation”—no bargain, but no longer as overpriced as they were in spring.

 

A reasonable expectation for total return over the next few years, say industry experts, is 6% to 7%. “The days of 20% returns, they’re gone,” says Mr. Kolitch.

 

Don’t be tempted to move into funds with yields above 4%, says Mr. Kirby: “The highest-yielding REITs are generally the most overpriced. You still have an awful lot of investors trying to pick up pennies in front of a steamroller.”

Anyone who overpays for lower-quality, higher-yielding assets could be crushed if interest rates rise sharply. The Fed promised again this week to keep rates low, but you never know.

 

Those who already own a REIT fund with annual expenses under 1% and a conservative yield below 4% should hold on.

 

Those who don’t should watch and wait: If interest rates take a sudden jump or stocks take off again, REITs could go on sale. As anyone who has ever bought a house knows, you will do best if you wait for a buyer’s market.

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