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A close look at the 12-year performance history of the domestic REIT sector provides two conclusions. One, valuations seem unimportant as a determinant of returns. Two, the yield differential between real estate investment trusts and government bonds, which mathematically is the primary candidate as the driver of performance, points to flattish returns in the next 24 months.

To check the influence of valuations on the sector, I leaned on the work of Merrill Lynch quantitative strategist Savita Subramanian. Every year, the strategist publishes a 60-plus page report that uses 25 years of performance data to uncover the valuation method that works best in each market sector. For REITs, Ms. Subramanian highlights trailing and forward price-to-earnings ratios.

The S&P/TSX Capped REIT Index (I used the simple return index because the total return index has a shorter history) is currently expensive in terms of trailing earnings, with a trailing P/E of 23 times versus the 10-year average of 16.9 times. In terms of expected earnings, however, the subindex is inexpensive with a forward P/E of 12.6 times compared with the 10-year average of 17.7 times.

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A spread to watch

What relative yields can tell investors in

the Canadian REIT sector

S&P/TSX Capped REIT Index yield minus

5-year Gov’t of Canada yield (pct. points)

12

10

8

6

4

2

0

-40

-20

0

20

40

60

80

100

120%

S&P/TSX Capped REIT Index: Forward 24-month returns

THE GLOBE AND MAIL, SOURCE: scott barlow

A spread to watch

What relative yields can tell investors in the Canadian REIT sector

S&P/TSX Capped REIT Index yield minus

5-year Gov’t of Canada yield (pct. points)

12

10

8

6

4

2

0

-40

-20

0

20

40

60

80

100

120%

S&P/TSX Capped REIT Index: Forward 24-month returns

THE GLOBE AND MAIL, SOURCE: scott barlow

A spread to watch

What relative yields can tell investors in the Canadian REIT sector

12

S&P/TSX Capped REIT Index yield minus

5-year Gov’t of Canada yield (pct. points)

10

8

6

4

2

0

-40

-20

0

20

40

60

80

100

120%

S&P/TSX Capped REIT Index: Forward 24-month returns

JOHN SOPINSKI/THE GLOBE AND MAIL, SOURCE: scott barlow

These valuations are conflicting but unlikely to matter in the next 24 months. For every week starting with Nov. 16, 2007, I compared both of the index’s P/E ratios to the subsequent two-year returns. As it turns out, the correlation between both P/E ratios and future performance was insignificantly low.

The relative yield of the index – the distribution yield of the REIT index minus the yield on the five-year Government of Canada bond – did, on the other hand, have a strong relationship with forward two-year returns.

Each dot on the accompanying scatter chart represents the yield spread for every week starting late November, 2007, and the performance of the subindex in the following 24 months. The dot in black (it’s only black so I can use it as an example) is from Dec. 5, 2008. At that time, the S&P/TSX Capped REIT Index had a yield 10.8 percentage points higher than the five year bond (y-axis) and the index rose 83.5 per cent (x-axis) in the two years ending with early December, 2010.

Right now, the REIT index yield is 4 per cent higher than the bond yield. Using the trend line on the chart, investors can expect a flat return (not including dividends) for the REIT index in the next 24 months. The trend line also indicates that yield spreads significantly below 4 per cent make negative returns far more likely.

Regression analysis such as this is not meant to be a pinpoint accurate predictor of future results – it uncovers the relationships that in the past have been the most important drivers of returns. In this case, investors in the Canadian REIT sector can see the importance of relative yields.

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