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
- Check out Wiki for the detailed intro
- REITs are corporations that invest in real estate assets; residential, commercial real estate, even timberland. There are also REITs that invest in mortgages and mezzanine loans
- REITs enjoy a tax-advantaged status; they can avoid corporate taxes but are required to pay out 90% of their taxable income as dividends
- REIT dividends are not qualified, thus will be considered ordinary income on your tax return. Hence, most people like to hold REITs in tax deferred accounts (IRA, 401k, etc.)
Pros: Why investors like REITs
- A steady dividend flow. The broad market yields maybe 2% (VTI, U.S. Total stock index fund), but REIT ETFs yield above 4% (as in VNQ, Vanguard REIT index ETF). Some individual REITs have yields in the high single digits, even double digits, not bad in this low-yield world
- Mr. Money Mustache likes REITs because some of them have dividend yields that compare favorably with his former rental property yield. Why not get the same rental income with less of a hassle? No more late night calls from tenants about the toilet not flushing!
- In the past, REITs offered a pretty good inflation hedge. To be sure, stocks in general hedge inflation over the long-term, but rental properties seem to rent out at prices that track inflation fairly well, and thus REITs enjoy the aura of a certifiable inflation hedge. Besides, in the CPI, the share of housing inflation is above 30% in the overall index, and even above 40% in the core CPI index (excluding volatile food and energy components), so just by construction CPI and housing inflation track each other well.
- REITs had a very nice run since the equity market trough in early 2009, up almost 24% annualized, which is significantly higher than the overall market or the Vangaurd high dividend yield equity ETF, see table further below
- REITs will continue to do well if the economy keeps chugging along, home prices don’t drop and interest rates stay low or at least don’t snap back up very rapidly
What is the source of the recent impressive REIT returns?
Let’s take a look at the returns in some of the popular ETFs:
- VTI: Vanguard US Total Stock ETF
- IEF: iShares 7-10 US Treasury ETF (why a bond ETF? Patience, that will become obvious below!)
- VNQ: Vanguard REIT ETF
- 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.
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.
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
- As we saw above: You get higher dividend yield with REITs but also higher risk (20.4% in VNQ versus 12.5% in VYM). You would need a really large appetite for dividend yield if you accept 60% higher risk in exchange for raising the dividend yield from 3.3% to 4.5%. And it’s not that the high dividend stocks inside VYM are less profitable, they merely reinvest more of their profits in their business for future growth. So the 1.2% lower dividend yield is not lost, it simply remains on the company balance sheet.
- Because REITs have to pay out such a large share of earnings, there are limited opportunities to grow their business.
- PE ratios and Price to book ratios are quite high. If you thought spending $200,000 on a rental property was bad, paying $200,000 for only $100,000 or rental property is even worse. For example, one of the largest publicly traded multi-family REITs (and one of the largest stocks in VNQ) is Avalon Bay (Ticker: AVB), with a current dividend yield of 3%, as of 5/31/2016. That seems awfully low to me! If they pay out 90% of profits their net rental yield is only 3.3%. The company has a market cap of $25b, but according to its balance sheet, assets are only $17b. Minus $10b in liabilities (loans) you get only $10b in net assets as of 12/31/2015. Sure, accounting rules mandate that REITs have to low-ball their assets and keep them at acquisition value instead of adjusting to market value (as pointed about by a commenter). But it’s still a catch-22: either the asset value is much higher but the rental yield is really low, or the rental yield is very competitive (8.25% yield when based on net book value of assets) but then the price of stock has been bid up to 2.5 times the fair value. Either way, it’s not a pretty picture. Of course, a high price-to-book ratio is nothing bad per se; lots of high-growth companies have those. But REITs have limited growth potential; see bullet point above!
- Related to the bullet above, REIT yields are quite low, by historical standards. They were closer to 6% 10 years ago, now only a bit over 4%.
- As we showed above, REITs have behaved more like a mix of highly levered stocks and bonds over the past few years. That by itself is not a bad thing, but it means if the era of low interest rates were to end (watch out for June Federal Reserve Meeting!), REITs could get hurt, just like nominal bonds would. Rapidly rising interest rates could be bad for REITs if all the yield chasers try to panic sell. Intriguingly, it could be an inflation shock with the resulting losses of interest-sensitive assets that can send REITs tumbling. Rising interest rates are poison for bonds, and if REITs keep behaving like they have before they could give back that excess return over VTI and VYM pretty fast. Sure, inflation would also lift the underlying asset book values within REITs, but recall that the price to book value is so high right now, prices could fall by a lot before even getting close the slightly increased book value. In other words, who cares if the book value of that REIT goes up, the price to book ratio can move much more rapidly!
- Another economic slowdown and/or drop in real estate prices will be bad for REITs. In 2008/9 REITs dropped by even more than the overall index: the Vanguard ETY VNQ dropped by 75%, compared to a 57% drop in the S&P500 (total return, drop from peak to bottom).
Then what’s the alternative to REITs?
- If you are looking for a pure inflation hedge, keep in mind that equities in general are already an investment into the productive capacity of the economy and are thus real assets, i.e., an inflation hedge. Equities may suffer in the short-term from fears the central bank might step on the breaks too hard, but eventually firms will have the pricing power to raise prices and profits in line with inflation.
- If you want a strong correlation with CPI prices, think energy equities, though they have their own issues ever since commodity prices started going south. Moreover, they are included already in your index fund already, so why load up on them even more?
- If you want high dividend yield then think high dividend stocks (duh!) such as the Vanguard High Dividend stock ETF (VYM). They seem to have less nominal bond exposure (risk), but almost the same yield as REITs.
- If you seek exposure to the U.S. housing market, why not Home Depot (HD) or Lowe’s (LOW), who also benefit from a rising U.S. housing market. Or home builders? Again, they will already be in your index fund, so why double down on the risk?
- Real Estate Crowd-Funding (e.g. fundrise.com, peerstreet.com, or patchofland.com). One caveat here is that many of these investments are not exactly real estate investments, but rather high-risk, high-yield loans with real estate as collateral. That’s a very incomplete substitute to a true real estate investment, where you get rental income and participation in home price appreciation.
- Direct real estate investment. Unfortunately, that also has all the disadvantages of being a landlord: an illiquid investment, hassle with tenants, risk of lawsuits, etc. But if one can get a 4% yield on rentals after all costs, fees, maintenance, repairs and taxes, it would be a very attractive passive income source to sustain a high withdrawal rate plus inflation adjustment, plus low correlation with the equity portfolio.
- Private Equity funds that invest in Real Estate. This would be an option for people who want ownership of real estate, but keep it as a passive investment. The disadvantage is that these funds operate in a very unregulated world and that such investments are highly illiquid.