Swedroe: Breaking Down REIT Prices

As with all financial assets, real estate investment trust (REIT) valuations should equal the discounted present value of expected future cash flows. REIT prices thus reflect the growth potential of cash flow (rents, expenses) and/or the time variation in expected returns (interest rates and risk premium, which is the discount rate).

Given currently low yields on REITs, an important question for investors is: Do high prices today relative to dividends (low dividend yields) mean that there are optimistic expectations of future dividends? Or, do high prices relative to today’s dividends imply low future returns?

Kevin C.H. Chiang sought to answer these questions in his study, “What Drives REIT Prices? The Time-Varying Informational Content of Dividend Yields,” published in Volume 37, Issue 2 (2015) of the Journal of Real Estate Research. In it, Chiang examined the question of what drives REIT prices.

Chiang noted in his paper, which covered the period 1981 through 2011, that there is “good evidence suggesting that the relative importance of these sources may evolve as the real estate industry grows and matures.”

He cited changes within banking and securitized real estate regulations, and the increasing role of capital markets in real estate investing and financing. He also cited several papers documenting a structural change in REIT pricing in the early 1990s.

He goes on to add: “It is now almost a standard practice in the REIT pricing literature that REIT return datasets are partitioned into the vintage and new REIT eras using the Revenue Reconciliation Act of 1993 as the defining event.” Thus, his study followed this convention and investigated whether the informational content of REIT dividend yields exhibits a shift around 1993.

Study Results

Among his interesting findings was that during the sample period, office/industrial REITs had a slightly negative nominal average dividend growth rate of -0.03%. Residential REITs had the highest average nominal dividend growth rate, at 0.68%. The mean growth rate for equity REITs was just 0.25%. Given that inflation was 3.15% during this period, the real rate of dividend growth, even for the sector with the highest growth rate, was -2.47%. For equity REITs, on average, the real growth in dividends was -2.9%.

Chiang found that during the vintage REIT era, from 1980 through 1992, REIT dividend growth was predictable for REIT aggregate dividend yields at both a short and long predictive horizon, and that the predictability increased with the time horizon.

For example, at a three-year horizon, approximately 43% of the variation in dividend growth is forecastable ahead of time from dividend yields. In addition, dividend yield coefficients are negative and statistically significant. Low dividend yields predict high growth in future dividends.

However, over the new REIT era, from 1993 through 2011, Chiang found that there was virtually no evidence of dividend growth predictability. Rather, a positive predictive relationship from dividend yields to REIT returns emerged.

For example, at a three-year horizon, roughly 33% of the variation in aggregate REIT returns is forecastable ahead of time from dividend yields. In other words, low yields no longer forecasted high growth in dividends. Instead, they forecasted low future returns. And, in general, the data was statistically significant at the 1% confidence level.

Chiang concluded that the “results also support the notion that there is a fundamental shift in the REIT pricing structure beginning in 1993.” His findings are consistent with those of Eugene Fama and Kenneth French in their 1988 paper, “Dividend Yields and Expected Stock Returns,” published in the Journal of Financial Economics.

Fama and French found that aggregate dividend yields predict aggregate stock returns, but not aggregate dividends. And today, the conventional wisdom in financial economics is that the time variability in expected returns is the dominant component of market price variability.

Current Implications
For today’s investors in REITs, Chiang’s study has important implications. The Federal Reserve’s zero-interest-rate policy has led many cash-flow-based investors to seek investments that provide higher yields than those available on safe fixed-income investments. REITs have been among the primary beneficiaries. The subsequent cash inflows drove REIT prices higher. As a result, valuations have risen and dividend yields have fallen.

As I write this, the current yield on Vanguard’s real estate index fund (VGISX) is about 3.2%. What does that imply about future expected real returns? If one assumes that future real growth in earnings will be consistent with the historical real growth rate of -2.9%, and if valuations do not change, then investors in REITs should be expecting a real return of just 0.3%.

We can compare that 0.3% real return for REITs with the expected real return for global equities in general. A common metric used to forecast equity returns is the Shiller CAPE 10 ratio, with an adjustment for the fact that the metric uses average real earnings over the prior 10 years. Assuming real earnings grow about 2% a year, we would need to multiply the CAPE 10 earnings yield by 1.1 [1 + (5 x .02)].

The S&P 500 has a current CAPE 10 of about 26, producing an earnings yield of about 3.8%. Adjusting for the lag, we have a real return forecast of 4.2% [3.8 x 1.1]. Using the same set of metrics produces a real return forecast for the MSCI EAFE and MSCI Emerging Markets Indexes of about 7.3% and about 9.2%, respectively.

Not only does the 0.3% expected real returns for U.S. REIT investors look unattractive in comparison, it has only about a 0.1% risk premium above the real return on virtually riskless 10-year Treasury inflation-protected securities (TIPS). Forewarned is forearmed.

Related ETF: Vanguard REIT Index Fund (VNQ | A-91)

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.