The last time the domestic real estate investment trust sector’s yield advantage over risk-free government bonds was this small was 2007. In that case, steep losses persisted in the following 24 months, thanks to the financial crisis.
Do I think the average REIT will drop 40 per cent in the next two years this time, as it did then? No, but there is reason for investor concern.
The current indicated yield on the S&P/TSX REIT index is 3.8 per cent, and the current five-year government of Canada bond yield is 2.6 per cent. This makes the yield differential or “spread” 1.2 percentage points for the average REIT.
The average spread over the past 15 years (the maximum data available) has been 3.9 percentage points. In strict yield terms, REITs offer a much smaller benefit relative to bonds now – the lowest since June, 2007.
I compared the yield spread with REIT index performance over one, two and three years to see whether relative yields have influenced sector performance. They have certainly been connected.
The strongest statistical relationship I found was between the yield spread and forward 24-month simple (not including dividends) REIT index returns. In short, the more the REIT’s yield exceeds the bond yield, the higher return investors can expect. Unfortunately for investors in the current situation, the reverse has also been true.
The accompanying chart details the trend. Each dot represents the yield spread for every month-end since May, 2006, and the performance of the REIT index for the following two years. The dot furthest right, for example, shows the results from December, 2008 (although dates are not plotted on scatter charts). Then, the yield on the REIT index exceeded the five-year bond yield by 9.5 percentage points (X-axis), and the index climbed 63 per cent (Y-axis) between December, 2008, and December, 2010.
Diminishing yield spread vs. future REIT returns
S&P/TSX REIT index fwd. 24-mo. simple return
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S&P/TSX REIT index yield minus 5Y Gov't of Cda bond yield
THE GLOBE AND MAIL, SOURCE: BLOOMBERG; SCOTT BARLOW
Diminishing yield spread vs. future REIT returns
S&P/TSX REIT index fwd. 24-mo. simple return
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S&P/TSX REIT index yield minus 5Y Gov't of Cda bond yield
THE GLOBE AND MAIL, SOURCE: BLOOMBERG; SCOTT BARLOW
Diminishing yield spread vs. future REIT returns
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S&P/TSX REIT index fwd. 24-mo. simple return
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S&P/TSX REIT index yield minus 5Y Gov't of Cda bond yield
THE GLOBE AND MAIL, SOURCE: BLOOMBERG; SCOTT BARLOW
The upward sloping trend line on the chart reaffirms a pattern whereby investors buying REITs when the distribution yield is more above the bond yield have enjoyed better returns.
The roughly 15 years of data we have is not sufficient to draw hard and fast investment rules. This is important to keep in mind because the analysis on the chart projects that the REIT index will decline between 30 and 40 per cent in the next two years. If we find 1.2 per cent on the x-axis, the current yield spread, and follow that point upward to the trend line, it intersects the Y-axis in that range – between minus 30 and minus 40 per cent.
This is not reason for REIT investors to panic, in my opinion – there are a lot of necessary caveats. The previous big losses were caused by a once-in-a-generation global financial crisis that is unlikely to reoccur any time soon. In addition, many REITs will be able to increase payouts as the economy recovers sustainable momentum, and restore a more attractive yield spread.
It remains the case, however, that the average yield on domestic REITs is now much less attractive compared with bonds and this makes future strong performance less likely. There will be investors who will sell their REITs, with their expected higher yields, and buy slightly lower-yielding, but guaranteed, government bonds.
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Scott Barlow