The Federal Reserve’s low interest rate policy of the post-ﬁnancial crisis era has been blamed (or given credit, depending on your perspective) for high valuations on all types of financial assets.
For example, Shiller’s 10-year cyclically adjusted price-earnings (CAPE 10) ratio has risen from a historical average of about 17 to in excess of 29. And real estate investment trusts (REITs) are no exception.
As Stijn Van Nieuwerburgh shows in his April 2017 paper “Why Are REITs Currently So Expensive?,” REIT valuations have changed over time. He showed that for the period 1972 through 2004, the price-dividend ratio (the inverse of the dividend yield, or D/P) on publicly owned REITs ranged between about 12 and 18.
The commercial real estate boom leading up to the global financial crisis, which began in 2007, pushed valuation ratios outside this range, as high as 27.5 in the ﬁrst quarter of 2007.
Implications Of High Valuations
“A sharp correction in the last quarter of 2008 and the ﬁrst quarter of 2009 halved property valuations and brought them to the lowest levels seen. Valuation ratios of public real estate companies recovered sharply in the boom that followed. By the ﬁrst quarter of 2010, REITS were trading above pre-crisis peak levels. Valuations have remained in the 24.5-30.5 range ever since.” His paper investigated the implications of high valuations.
First, using common asset pricing models, Van Nieuwerburgh showed that there have been important changes in the nature of risk that is priced into the REIT markets. We can see that for ourselves using the regression analysis tool available at Portfolio Visualizer.
We’ll examine the results for Vanguard’s REIT Index Investor Fund (VGSIX), the largest REIT fund, with assets of more than $60 billion. From June 1996 through December 2007, the fund had the following loadings: beta 0.54, size 0.38, value 0.75 and momentum -0.05. And the R-squared value of the model was 37%.
However, from January 2008 through December 2016, the loadings shifted to: market 0.98, size -0.04, value 0.37, and momentum -0.14. And the R-squared value rose to 61%. Clearly, compared with prior periods, stock risk became much more important, while size and value risk became less important.
Increased Risk At Wrong Time
Van Nieuwerburgh himself noted that “the stock beta of equity REITS peaks at 1.75 for the 5-year periods that end around 2009-10.” In other words, market risk for investors in REITs was increasing at exactly the wrong time. By the end of the period, the five-year market beta had fallen to 0.75, still well above historical levels.
Van Nieuwerburgh then looked at the exposure of REITs to bond risk. He found that in addition to having larger exposure to market beta, the interest rate risk of REITs rose sharply over the last decade. The 10-year Treasury bond beta surged from zero pre-2005 to 1.5 by December 2016. This indicates that at a time when many are concerned about the potential for rising interest rates, REITs are now subject to significant interest rate risk.
The twin findings of a dramatically higher market beta and the huge jump in the 10-year Treasury bond beta means that investors in REITs are now subject to much greater risks than they historically experienced.
High Risk & High Valuations
And this comes at a time when, as noted earlier, valuations of stocks and bonds are at historically high levels—not exactly a good combination. It’s one thing when you have lots of risk and high risk premiums that result from low valuations, which was the case as we began 2009; it’s very different from having high exposure to risks when valuations are high, and expected returns are therefore low.
Van Nieuwerburgh explained that the higher valuations must reflect low future expected returns, higher rates of growth in dividends or a combination of both. Based on his factor-based analysis, he concluded that “the high valuation ratios of the past seven years must have been due to high dividend growth expectations.”
Specifically, he found that based on historical factor premiums, “U.S. REIT investors price in dividend growth expectations of 20 to 30% per year over the 2010-2016 period.”
Reversion Of Growth Expectations
He concluded that, since growth expectations are far above historical average growth rates, a reversion of growth expectations toward historical norms will result in a drop in REIT prices, unless it is offset by a simultaneous decrease in REIT risk premiums—investors become willing to accept much lower returns from REITs.
His analysis led him to conclude that “historically low interest rates or lower expected returns more broadly cannot account for the high prices. Rather the high prices reﬂect optimistic expectations about future income growth from commercial properties. … Indeed, our analysis shows that real estate has become more vulnerable than ever to an increase in interest rates and/or an economic contraction.” He then concluded that his analysis showed that “the REIT market looks just as ‘frothy’ in July 2016 as it did in February 2007.”
Van Nieuwerburgh extended his analysis to international REITs. He found that stock and bond betas were higher than they were historically and similar to those of U.S. REITs. However, he did not find the same historically high growth expectations for dividends internationally that he observed in the U.S.
“In mid-2015, implied dividend growth in global REITS is around 5% per year, 15% points below the level for the U.S.” He concluded that international REITs were fairly valued.
More Stock And Bond Risk
Van Nieuwerburgh showed both that REIT valuations had dramatically increased and that REIT investors are now exposed to more stock and bond risk than has historically been the case. When forecasting future returns, we normally look to the earnings yield, or earnings-to-price ratio (E/P). However, REITs trade on a cash flow-to-price basis (CF/P). While the standard industry metric is funds from operations (FFO), Morningstar provides us with the similar CF/P information.
As of March 31, 2017, Vanguard’s REIT Index Investor Fund (VGSIX) CF/P ratio was 7.0. This compares with 8.9 for the Vanguard 500 Index Investor Fund (VFINX) and to 15.7 for the SPDR S&P 600 Small Cap Value ETF (SLYV).
On this basis, REITs are trading about 27% more expensively than the S&P 500 Index at a time when investors are concerned that the Shiller CAPE 10 on May 1, 2017 for the S&P 500 was 29.3, producing an earnings yield (the best forecaster we have of future real expected returns) of just 3.4%.
Investors should also be aware that, over the long term, the real growth in REIT dividends has been about -0.7% (the NAREIT equity index produced $6.05 in dividends in January 1972 and $26.17 in May 2017, an annualized increase of 3.27% versus 4.01% inflation).
The current SEC dividend yield on the Schwab U.S. REIT ETF (SCHH) is about 3.4%. Subtracting 0.7% from that figure provides a forecasted real return of just 2.7%, about 2.3% more than the current yield on 10-year Treasury inflation-protected securities.
While no one knows what the future holds in terms of REIT returns, at the very least, investors in REITs should be aware of the nature of these changes and their implications.
While my crystal ball remains cloudy, as always, and a wide variety of outcomes are possible, if REIT valuations remain unchanged, future returns are likely to prove disappointing. And if either the risk premium that investors require rises, or interest rates rise, less favorable outcomes could result.
Of course, it’s always possible that risk premiums and/or interest rates will fall, leading to stronger-than-expected REIT returns. At the very least, investors should be aware that REITs are now more vulnerable to an increase in interest rates and/or an economic contraction, and it’s important to stick to your plan, rebalancing along the way.
If you have been thinking of increasing your allocation to REITs to generate more cash flow, this should serve as a cautionary warning. Forewarned is forearmed.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.
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