Relative yields suggest REITs will keep going strong

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The current yield on Canadian real estate investment trusts suggests that the sector will continue to climb the wall of worry and generate significant positive returns for the next 12 months.

The attractiveness of REITs is dependent on their yields relative to government of Canada bonds. For example, a REIT yielding 10 per cent now would be a tremendously compelling investment, but not worth investors' time in 1990, when 10-year Canada bonds yielded 11 per cent.

This week's chart shows the effects of relative yields on future performance. The horizontal axis shows the spread – the difference in yield between the S&P/TSX REIT index and the five-year government of Canada bond.

The first bar on the left, for instance, shows that when REIT yields are between equal and 1 per cent higher than the five year bond, the average future 12-month performance of the REIT index is a 17-per-cent decline.

The trend is clear and consistent – the larger the spread, the more positive the future return on the index.

The current yield on the REIT index is 5.74 per cent and the five-year bond yield is 1.63 per cent. This makes the spread 4.1 per cent, a level where historically REITs have returned 11 per cent in the following year.

This is not just a stock market, asset price phenomenon. Higher spreads suggest either lower borrowing rates or higher levels of income from the real estate properties. Lower interest rates are a major source of profits for real estate owners, as they can refinance mortgage loans with lower interest payments, reducing operating costs.

The five-year government of Canada yield spiked almost a full percentage point during 2013 – narrowing the yield differential between REITs and government bonds – and as a result, the S&P/TSX REIT Index declined 10.5 per cent.

So far, 2014 has offered much better conditions for dividend-seeking equity investors. The five-year bond yield has declined to the current 1.6 per cent from 1.94 per cent, increasing the spread, and true to form, the REIT index has provided a total return close to 4 per cent year to date.

There are no guarantees in the market, and investors must be aware that the usual "past performance is no guarantee of future returns" disclaimers apply. The optimistic indicators of future performance in the real estate sector are based on the full data set available, monthly from 2006, which does not encompass all potential market conditions. Still, the results of this analysis offer legitimate support for investors in the sector at a time when real estate-related doomsaying is louder than ever.