REIT stocks rallied 28.6% in 2010 and by many valuation metrics REITs have become expensive. REITs have long been the most volatile of broad asset classes. And REITs’ returns have been highly correlated with equities. Why then does our company include REITs in our risk-controlled portfolios? (Portfolio Research currently allocates 2% to 7% of our investment portfolio to REITs)
Should you include REITs in your portfolio? Below I discuss some of the criteria to evaluate allocation to REITs.
Performance/valuation
While equities suffered a “lost decade” between 2000 and 2010, REITs did relatively well, having a compounded return of 6.1% during the 10-year period ending July 31, 2010 (compared to -4.5% for the S&P 500 Index during this same period). Since the financial crisis, REITs have been able to issue new stock and pay down debt. Though demand for office, retail and apartment space remains weak, the trend in job growth (highly correlated with real estate demand) is positive. Meanwhile, new construction has dropped off a cliff, so occupancy, rents and thus REIT revenue could rise significantly if in fact the economic recovery continues to gain strength. REITs (RWR) provided a dividend yield of 3.4% at the end of 2010. This is relatively attractive in a climate of historically low bond yields, (though some argue that given their structure and risk they should offer a much higher premium to income producing equities). Several valuation metrics from the December 8, 2010 Fidelity Viewpoints suggest REIT stock prices are expensive:
- On a price/FFO basis, REITs traded at a multiple of 15.2, which was above the category’s 11.8 historical average at the end of October,
- REITs historically have traded at a slight premium to the net asset value (NAV) of the properties they own, but were about 16% above NAV as of the end of October, and
- REIT dividend yields at about 100 bps higher than the 10-year Treasury yield, is slightly below the average spread of 122 bps.
Volatility
REIT returns have been the most volatile of the asset classes we follow. The value of real estate investments were devastated in the financial crisis of 2007 and 2008 when investors feared that real estate companies would be unable to meet their short-term debt obligations and in the spiraling panic and fear of bankruptcy, REIT prices dropped by more than half. The performance of REITs has become more volatile – for example, since 2007, REITs have been much more volatile than the broader U.S. stock market, with a standard deviation (measure of volatility) of 40.3, compared to 24.5 for the broader market. From the start of the asset class in 1972 to 2006, the standard deviations for REITs and U.S. stocks were 12.9 and 13.8, respectively. Over the past 60 days REIT volatility has been 17.47 versus 13.94 for broad U.S market.
Correlation
The performance of REITs has become more correlated with the broader U.S. stock price movements. From 1972 to 2006, REITs had a 0.5 correlation (modest) with the broader market; over the past four years REITs have had a very high correlation (0.9) to other stocks, though over the past 60 days it has dropped to 0.7. On the other hands REITs provide diversification with bonds – current correlation is only 0.2.
REITs as an Inflation hedge
REITs have historically been an effective inflation hedge – along with TIPs and commodities. REITs have been an effective inflation hedge for over 30 years, and particularly so when inflation has been at its worst. Because REITs invest in a hard asset (i.e., property) that may be expected to adjust higher with the rate of inflation. When inflation averaged more than 9% per year during the 1970s, REIT stocks delivered an average total return of 18% per year, with income representing 10.3% of that return. By comparison, investment-grade bonds advanced 5%, with price declines detracting from total returns.