Real-estate investment trusts, or REITs, have delivered outstanding performance in the past year, and all of the factors that have fueled the sector’s rally remain in place. But what happens if Treasury yields start to rise?
REITs Hitting on All Cylinders
Click to Enlarge For now, REIT investors have nothing to complain about. The Dow Jones Real Estate Investment Trust Index is up 14.9% year-to-date, which compares favorably with the 13.4% gain for the Select Sector SPDR-Financials ETF (NYSE:XLF) and the 8.7% return of the broader U.S. equity market, as gauged by the SPDR S&P 500 ETF (NYSE:SPY).
On Friday, the iShares Trust Dow Jones U.S. Real Estate Index Fund (NYSE:IYR) touched a new 52-week high and closed at its highest level since just before the 2008 financial crisis hit in full force.
Two factors are underpinning the outstanding performance for the REIT sector. First, fundamentals remain strong: During the first quarter, more than half of the U.S.-traded REITs beat analysts earnings estimates. Strength is evident across all sectors, as evidenced by rising lease rates for mall space, higher per-room revenue rates for hotel operators, and robust apartment leasing levels. Second, and most important, investors remain on the lookout for any sector that can provide them with income during a time of plunging Treasury yields.
Click to Enlarge In this sense, REITs aren’t alone. This chart, which uses ETFs to represent the various asset classes, illustrates that REITs are part of a larger trend than involves dividend-paying stocks, utilities, MLPs, preferred stocks and the higher-yielding segments of the bond market: corporates, high yield and the emerging markets.
As Treasury yields have plunged in the past 12 months, all of these market segments have benefited accordingly. And, as the chart shows, they have all been tightly correlated.
The Impact of Rising Rates
In this sense, it seems as though REITs might be vulnerable here. If Treasury yields spike, REIT prices should fall as their relative yield becomes less attractive, right?
Not necessarily. This report from CBRE Clarion Securities is more than a year old, but it’s packed with information about the impact of Treasury yields on REITs. CBRE measured REIT performance in 12 separate periods of rising Treasury rates from 1991 through 2011 and found that the sector provided an average gain of 9.3% during those times. While lower than the 12.6% return of the S&P 500 in the same periods, this nonetheless shows that a rise in bond yields doesn’t necessarily have to hurt REITs. The reason is that higher yields often are accompanied by improving confidence, which in turn are a positive for the real estate market.
Recent history supports this long-term data: When Treasury yields spiked in the nine trading sessions from March 6 to March 19, IYR rose 4.1%.
The report provided two other important takeaways, one positive and one negative.
The good news is that when the spread between the 3-month and 10-year Treasury is between 100 and 200 basis points (at Friday’s close, it stood at 141), REITs have returned a blistering 18.1% — and outperformed the S&P 500 — in the subsequent 12 months. This would indicate a positive outlook for REITs right now.
On the other hand, a flattening yield curve is a negative for REITs. That’s exactly what we’ve witnessed in recent months, as long-term rates have fallen and short rates have been pinned by the Fed’s zero-rate policy. Based on the findings in the CBRE report, a logical conclusion is that the real danger for REITs won’t occur until the spread between the 3-month and 10-year notes moves closer to 100 basis points. While that leaves plenty of room from here — it would require a drop in the 10-year from 1.41% to 1.03% — in reality the trouble might start sooner this time since a decline into the 1.2%-1.25% range could signal a level of stress that would start to weigh on stock prices.
Conclusion
REITs still offer investors attractive yields relative to Treasuries. IYR yields about 3.4%, which is a 2-percentage-point spread that should indicate continued support for REITs. In addition, IYR’s move to a 52-week high is a positive technical signal.
Still, it’s important to keep an eye on the bond market. If the 10-year note breaks down to new lows, history shows that REIT investors may want to consider lightening up.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.
