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Declining government bond yields have been a huge driver of outperformance in the domestic real estate investment trust (REIT) sector. With bond yields on the rise, however, future returns are far more uncertain, and historic patterns point to flat performance for the sector in the year ahead.
This chart tracks the difference in yield between the S&P/TSX REIT Index and the ten-year Government of Canada bond. At the peak on the chart in December 2008, for instance, the black line shows that the spread between government bond yield (2.68 per cent) and the yield on the REIT Index (11.21) per cent was 8.53. The red line shows forward performance – the simple return of the index (excluding dividends) in the following twelve months.
The yield on any unit trust is important, but the annual payouts relative to government bond yields are even more so. In the current environment, a REIT with an eight per cent yield would be attractive. But if government bonds were also yielding eight per cent, the REIT would not far less interest – an investor would not be compensated for the added risk. It's clear from the chart that as the difference between government yields and REITs rises, future returns improve. The reverse case has also been true. When REIT yields fall closer to bond yields – the spread declines – future performance of the sector also suffers.
Between May 2012 and May 2013 (the last possible 12 month performance period to measure) the REIT index generated an uninspiring 2.9 per cent return before dividends. The spread has remained stable between three and three and a half per cent since that time which, ignoring all other factors, implies the next twelve months of REIT returns will be similarly sluggish relative to previous years.
The importance of government bond yields in deciding unit prices for REITS was on full display last month. The ten-year bond yield jumped 33 basis points and the index promptly shed 6.2 per cent. Importantly, the spread was maintained by the fall in prices of REITs, who increased their yields along with government bonds.
Interest rates are not the only driver of REIT returns. The economy matters, and there are market-related factors as well. For example, pension funds have pushed prices higher as they allocate assets away from resource-heavy domestic equity markets and into real estate assets where they expect more stable returns. This will continue to support asset values in the sector for as long as it lasts.
Government bond yields are, however, a dominant factor. If bonds stabilize here, then fine, REIT investors can continue to collect their hefty yields with unit values approximating current levels. Further increases in bond yields, however, will deliver more pain for investors in the sector.
Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here to read more of his Insights , and follow Scott on Twitter at @SBarlow_ROB .
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Scott Barlow