REITs – Still A No Go As Risks Are Rising

October 31, 2016

REITs – Still A No Go As Risks Are Rising

  • With yields going up, REITs have fallen 10% since the beginning of August.
  • With Italy issuing a 50-year bond at a 2.85% yield, we question the intelligence of the investors who bought them.
  • With REITs you are risking a 50% decline in the next few years for a 3.5% yield.

What’s Going On With REITs?

On August 3, 2016, we discussed Real Estate Investment Trusts (REITs) and how they weren’t a great investment at the time. You can read the article that introduces you to what REITs are and their risk and rewards here.

Since the beginning of August, REITs have fallen by 10% (iShares U.S. real estate ETF – IYR) compared to the S&P 500 which was practically flat.

figure-1-iyr-sandp
Figure 1: Real estate ETF – IYE and the S&P 500 since August. Source: Nasdaq.

The reason behind this decrease is an increase in interest rates. As interest rates increase, the yields REITs provide become less attractive. The current REIT yield is 3.41% but investors who invested at the beginning of August will have to accumulate three years of dividends to cover for the overall 10% decline in REIT prices since August.

Yields on treasuries have been consistently increasing since July and if they continue to do so, REITs will see more pain ahead. The current 10-year treasury yield is 1.76%, up 27.5% since the July low of 1.38%.

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Figure 2: 10-year treasury constant maturity rate yield. Source: FRED.

In order to see what will happen, we’ll further analyze the main factors that influence REIT volatility: yields and real estate prices.

Yields

As the above figure shows, yields have been increasing on the basis of an expected FED rate increase. But yields haven’t only been increasing in the U.S. The German 10-year yield treasury has returned to positive territory after reaching a negative yield of -0.2% this year.

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Figure 3: 10-year German treasury yield. Source: Bloomberg.

It’s possible that investors finally understood that the low yields we have now aren’t sustainable. As the first losses in yielding asset values came in, investors started to fear that the trend might be changing. With more and more companies and governments trying to lock in low yields, competition is surging and therefore the continuation in the current yield bounce is very possible.

It’s also logical as it’s best to keep your cash as cash than to exchange it for a negative yielding asset, or for one that gives you a meagre yield but has the potential of losing 50% of its value in the future, like stocks and REITs have. Also, the negative and low yields indicate that the buyers of those assets aren’t really investors but mostly speculators or shorts covering their positions. A continuation of the up trend in rates could spur a bigger sell-off in all types of yielding assets, including REITs.

One example of how crazy the yield chase was is Italy’s selling of $5.6 billion worth of 50-year bonds with a yield of 2.85% at the beginning of October. Anyone who knows Italy’s past and current economic state, future economic prospects, and political risks, knows that there is an absolute certainty that the value of those bonds, sometime in the next 50 years, will be 25% of their current value.

Italy will surely see higher rates, and even inflation, in the future as it has to cover its immense debt levels. Interestingly, just five years ago Italy’s three month notes carried a bigger yield. It’s obvious that those bonds were bought by speculators and not investors, or were bought by passive investing ETFs that buy a bit of everything on the markets as their policy is not to think, but just to diversify. Both approaches, speculating on higher bond prices and ETF investments, will see difficult times ahead when buyers realize or at least look at what it is that they own.

This awakening could already be happening now as global yields continue to increase. If the FED hikes interest rates in the coming meetings, more fuel will be added to the fire and will push REITs further down.

Real Estate Values & Occupancy

On top of the chase for yields, REITs have enjoyed increased commercial activity which has pushed commercial real estate prices up and increased occupancy rates.

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Figure 4: Realty Income (NYSE: O) occupancy rates. Source: Realty Income.

A recession would lower occupancy rates, lower asset values, and lower profits. This risk is emphasized by low interest rates and yields.

For example, Realty Income yields 3.95% at the current price of $59.25, but a recession or higher interest rates could easily send it down by a lot. Its price in 2009 was just a quarter of its current price, while its revenue was only a third of what it is now. A twofold increase in revenue shows that REITs really seized the opportunity given by low interest rates in order to buy as many assets as they could. Such a strategy is bound to backfire when interest rates on their debt increase and occupancy rates fall. Therefore, for a 3.5% yield, you are risking a 50% or even more in the next 5 years if a recession happens or interest rates further rise.

If a recession comes along, commercial real estate prices will be severely hit as demand evaporates.

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Figure 5: Yearly commercial real estate price growth. Source: FRED.

Conclusion

REITs are a great way to be exposed to real estate and not have to deal with tenants and toilet repairs. But as REITs seized the low interest rates and economic growth environment in the last 7 years to stretch their investments to the max, we might be looking at a small bubble.

Given the current increases in treasury yields and potential FED rate hikes, not to mention a possible recession in the next few years, there is great risk in owning REITs for a mere 3.5% yearly return.

If you are a long-term investor, REITs should still be avoided and bought when there is blood on the streets. At that point in time the risks will be low and potential returns high, and you will be able to buy the best REITs at huge discounts.

For now, as much as the yield might seem attractive, be sure to understand the risks before you invest or speculate on short term swings.