Swedroe: Important Changes In The Nature Of REITs

May 26, 2017

The Federal Reserve’s low interest rate policy of the post-financial crisis era has been blamed (or given credit, depending on your perspective) for high valuations on all types of financial assets.

For example, Shiller’s 10-year cyclically adjusted price-earnings (CAPE 10) ratio has risen from a historical average of about 17 to in excess of 29. And real estate investment trusts (REITs) are no exception.

As Stijn Van Nieuwerburgh shows in his April 2017 paper “Why Are REITs Currently So Expensive?,” REIT valuations have changed over time. He showed that for the period 1972 through 2004, the price-dividend ratio (the inverse of the dividend yield, or D/P) on publicly owned REITs ranged between about 12 and 18.

The commercial real estate boom leading up to the global financial crisis, which began in 2007, pushed valuation ratios outside this range, as high as 27.5 in the first quarter of 2007.

Implications Of High Valuations

“A sharp correction in the last quarter of 2008 and the first quarter of 2009 halved property valuations and brought them to the lowest levels seen. Valuation ratios of public real estate companies recovered sharply in the boom that followed. By the first quarter of 2010, REITS were trading above pre-crisis peak levels. Valuations have remained in the 24.5-30.5 range ever since.” His paper investigated the implications of high valuations.

First, using common asset pricing models, Van Nieuwerburgh showed that there have been important changes in the nature of risk that is priced into the REIT markets. We can see that for ourselves using the regression analysis tool available at Portfolio Visualizer.

We’ll examine the results for Vanguard’s REIT Index Investor Fund (VGSIX), the largest REIT fund, with assets of more than $60 billion. From June 1996 through December 2007, the fund had the following loadings: beta 0.54, size 0.38, value 0.75 and momentum -0.05. And the R-squared value of the model was 37%.

However, from January 2008 through December 2016, the loadings shifted to: market 0.98, size -0.04, value 0.37, and momentum -0.14. And the R-squared value rose to 61%. Clearly, compared with prior periods, stock risk became much more important, while size and value risk became less important.

Increased Risk At Wrong Time

Van Nieuwerburgh himself noted that “the stock beta of equity REITS peaks at 1.75 for the 5-year periods that end around 2009-10.” In other words, market risk for investors in REITs was increasing at exactly the wrong time. By the end of the period, the five-year market beta had fallen to 0.75, still well above historical levels.

Van Nieuwerburgh then looked at the exposure of REITs to bond risk. He found that in addition to having larger exposure to market beta, the interest rate risk of REITs rose sharply over the last decade. The 10-year Treasury bond beta surged from zero pre-2005 to 1.5 by December 2016. This indicates that at a time when many are concerned about the potential for rising interest rates, REITs are now subject to significant interest rate risk.

The twin findings of a dramatically higher market beta and the huge jump in the 10-year Treasury bond beta means that investors in REITs are now subject to much greater risks than they historically experienced.


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