2021 Real Estate Investing: Why REITs Are Worth Considering
If you are thinking about investing in real estate you should think about publicly traded REITs. REITs are not normally something I write about, but they should be part of any real estate investor’s arsenal of opportunities. The spread between the 10 yr Treasury and REIT yields is showing what is likely a great buying opportunity for REITs in a world with little to no yield. In this article I will not discuss individual REITs, but setup the big picture. It will be a rising tide lifts all boats, but certain subsectors of REITs will certainly benefit more than others. In this article I am only referring to equity REITs not mortgage REITS, there is a difference.
2020 In Review
No need to go into much detail how the COVID-19 Pandemic rocked the world. As it pertains to real estate it setup a very unique opportunity with falling bond and mortgage yields. The federal reserve cut overnight rates to basically zero. The 10 year US Treasury hit an all time low of just .6% in July as investors fled to safe haven investments. The 10 yr has since recovered to almost 1%. To put a 1% yield into perspective if you invested $10,000 today in the 10 year, you would have $11,046 in the year 2031. Not much of an investment, but it is better than the negative yields you see in Europe.
In 2020 the low yields did create an opportunity that still exists today for real estate investors. It was rare to see a 30 yr mortgage on an investment property below 4%, but we are now seeing some as low as 3.25% for individual investors. The drop in rates obviously does wonders for cash flow and has put additional fuel on the housing market fire.
In the public REIT world, most REITs took a significant hit due to the pandemic and market sell off. There was widespread concern over the effect lockdowns would have on tenants ability to pay rent. Entertainment REITs have taken the biggest hit followed by hotels. Office REITs have surprisingly not suffered as badly, but these tenants are still paying rent as their underlying businesses are performing despite most employees working from home. Retail REITs are still in question as lockdown orders and rules are always changing and affecting how they serve customers. Despite all the lingering questions the end result of all this is over 90% of tenants are still paying rent today.
Spread Between 10 Yr US Treasury and REIT Yields
If there is one chart that is the best indicator of relative REIT value it is the spread chart above. Take a moment to familiarize yourself and study this chart. REITs are in essence a bond proxy and thus as a whole have a yield that mostly tracks bonds. The thought process here is that they are relatively safe as they hold physical assets and produce bond like cash flow. They are not quite as safe as a bond so naturally investors desire a little more yield.
Historically this spread averages about 1.5% (150 basis points or bps) and has not been above 3% since the great financial crisis. Today it sits at nearly 4% which marks only the third time it has been this high since the early 1970s. REITs were created in 1960 and the NAREIT Yield Index was created in 1970, so we have about 50 years to compare. This is certainly a rare occurrence.
You can recreate the above chart with publicly available data on NAREIT and the St. Louis Fed websites.
What Happened in the 1980’s?
The 1980’s were a strange time especially for the yield spread that I mentioned above. Inflation and fear were rampant and it initially led to a sell off of real estate due to extremely high mortgage rates that pushed affordability to its limits. Real Estate in the 1980’s was not a great asset class to be in, but by some it was considered safer than investing in US government bonds. The negative spread is meaningful as future returns for REITs were lousy, more about future returns below.
What if Rates Rise Quickly?
If rates were to rise suddenly and quickly affordability would be a huge issue in real estate as mortgage payments skyrocket. This would lead to a slump and likely a housing crisis especially if it was anything close to what we saw in the 80’s. If you believe interest rates are set to rise then real estate is likely to underperform.
What if Yields Stay Low Over The Long Run?
If you believe low interest rates are here to stay then today is a great opportunity to buy either real estate or publicly traded REITs. If the yield on the 10 Yr Treasury remains unchanged, but the spread between the 10 Yr and REITs reverts back to its average of around 150 bps this means that equities could almost double. There are not a lot of times in history where you can foresee doubling your money in a relatively safe asset class like Real Estate. Granted this doubling would not happen overnight, perhaps over 3 or 5 years, but it is certainly well within the realm of possibilities.
The bigger question is what is normal for a 10 Yr Treasury? Some economists say 2%, some say 1%, but nobody knows. The Federal Reserve has also noted their desire to keep rates low and let the economy run “hot” to recover from the pandemic. Their prediction from September is rates would be near zero until 2023. If this does occur it will allow REITs to grow/increase rents while maintaining low cost to service their debt. The spread between the 10 Yr and REITs should also start to contract as the market prices in the growth of REITs.
The Federal Reserve has some very interesting commentary as to why the debt is serviceable and that essentially the net carrying cost is actually negative. This is a terrific article that has somewhat changed my simplistic perspective on government debt.
Europe May Be A Leading Indicator of US Yields
The US economy and Europe are closely tied together whether we like it or not. We tend to watch what the other is doing and if it seems to work we copy each other’s monetary policy. With that we can keep a close eye on Europe’s bond yields as an early indicator of trouble or opportunity. Europe has made headlines in recent years with negative yields and the average 1o Yr Bond in the EU just hit negative again recently. A negative yield is hard for many to understand as why would you lose money versus just holding cash? The short answer to this is they believe deflation will continue and bonds will become more negative and thus they are a worthy investment. To me this is losing money to speculate that someone is willing to lose more money, but I will leave that up to those who know more than me about it.
As you can see in the chart above, the US and the EU have very similar 10 year bond yields. As you follow it over time you can see how they tend to mimic each other. A savvy investor will keep an eye on what is going on across the ocean to consider whether it is relevant to them or not. Beware of reading too much into this, but just know that there are many additional sources of data out there that will hint at the future.
What Are Future Returns Expected to Be?
NAREIT is one of my favorite websites. The amount of data on there is outstanding and you can spend a lot of time reading about REITs and real estate in general. They commonly talk about the yield spread and anticipated future returns. Below is one of my favorite charts where they performed an analysis based on the yield spread of equity REITs to their actual returns.
As you can see when the yield spread is negative like the 1980’s the average forward returns are a dismal 3.4%. Increase that number to greater than 2% (remember we are at almost 4% now) and it goes up to 21%. Remember the doubling of REIT shares that was mentioned above? If you calculate 21% annual total returns over 4 years you come up with 2.14. That is pretty impressive!
While there is no predicting the future, the probability of good future returns from equity REITs is quite good based on the yield spread alone. The current yield spread is almost 4% and this has only occurred 3 times in the last 50 years. If interest rates were to rise suddenly it would likely reduce returns. There are no guarantees in life or investing, but when you can set yourself up for a better than average chance of success you are ahead of the pack.
Wishing You a Prosperous 2021 in Real Estate!
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Not responsible for accuracy or for updating this content, readers should perform their own due diligence and seek proper legal, financial, and tax counsel prior to making any decisions. Author is not a financial advisor, has no business relationship with any company mentioned, and is not receiving compensation for it. This is intended as an informational opinion piece only. Author has positions in publicly traded REITs, but has no intention of changing those positions of the next 72 hours. Original content is created by Greg Taft.
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