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REITs pros and cons

We live in a low-yield world. Interest rates are much lower than in recent history and this has spurred a mad “search for yield” whereby investors look for anything, really anything, that offers yield above the measly low interest rates currently prevailing in this country. REITs have greatly benefited from this trend and when my hairstylist starts telling me that he invests in REITs it makes me wonder if that sector might be a little bit overheated (brings back memories of the late 1990s when a different hairdresser in a different city gave out Tech company recommendations). Here are some pros and cons of REITs.

Papa ERN’s Low Yield Rant:

If you think yields are low here in the U.S., some government bonds across the globe now yield negative interest rates. You have to pay Switzerland, Japan and a few other countries for the privilege to loan them money. I could even see that some people are willing to pay a little bit to stash cash safely over night. But paying Switzerland to store money for 10 years or more? Lending money to Unilever for 0.08%? No thank you! But enough of my rant, back to REITs!

Intro: what’s a REIT

Pros: Why investors like REITs

What is the source of the recent impressive REIT returns?

Let’s take a look at the returns in some of the popular ETFs:

  1. VTI: Vanguard US Total Stock ETF
  2. IEF: iShares 7-10 US Treasury ETF (why a bond ETF? Patience, that will become obvious below!)
  3. VNQ: Vanguard REIT ETF
  4. VYM: Vanguard high dividend yield ETF

Since 2/28/2009 they all had pretty impressive returns, especially the REIT ETF, while the high dividend yield ETF had roughly the same return as the overall total market ETF. The bond ETF, naturally, has lower average returns, but also much lower risk and a negative correlation with equities. While VNQ had a very impressive run since 2009, it also significantly higher volatility than the overall market or the high dividend ETF.

ETF return stats 2/28/2009-5/31/2016

Let’s run a regression of the two high dividend ETFs to see what factor exposures to bonds and equities they had during the current bull market. This regression asks the question, what portfolio of VTI and IEF (potentially levered) would have best explained the observed performance (monthly returns in excess of cash) of VNQ and VYM? The factor exposures (betas), standard error of estimates and R² (measure of regression fit) are in the table below.

ETF Factor Model regressions (monthly data 2/28/2009-5/31/2016)

It appears that the REIT ETF behaved like a highly levered portfolio of stocks (116% weight) and bonds (85% weight). That’s not bad by itself, given how well both bonds and stocks performed. But VNQ also had a negative intercept, which means that on average that replication of VNQ with VTI and IEF would have outperformed the actual ETF by 1.2% p.a. Moreover, the measure of fit is low, which means that the REITs ETF has a lot of additional volatility on top of this simple factor model.

Thus, VNQ has been a levered portfolio on steroids since 2009, plus a lot of volatility that’s not just uncompensated, but even slightly detracted from the performance. Suddenly the REIT performance looks a bit less impressive.

The high yield ETF (VYM) on the other hand had only relatively little bond exposure and also a less than 100% equity beta. The ETF also outperformed this simple replication as evidenced by the positive intercept.

Which brings us to the cons:

Cons: Why we should be suspicious of REITs right now

Then what’s the alternative to REITs?



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