Find the Biggest Yields and Capital Gains with This Indicator
By Tom Dyson
April 9, 2008
Across from my house, a commercial property is up for lease. It used to be a car dealership. But the car dealership has gone. Now it's just a concrete runway with a glass hut in the center. The local kids skateboard there. They burn fires and break bottles at night. I can hear them sometimes from my bedroom.
Across the street is a supermarket. I'd say it gets about five customers an hour. The last time I went in there, the cashiers were amusing themselves by cussing over the intercom system.
Next to the supermarket are a dozen small storefronts. Half of them are empty. It's the same way with the retail development next to our office. The anchor store – a supermarket – is still there, but I never have to wait in line. Most of the windows in the shopping arcade are dark and lifeless. If you press your nose to the glass, you'll see wires hanging from the ceilings and old wooden blocks scattered on the ground. Dick's Wings and Hallmark both left last year.
Real estate investment trusts (REITs) are huge portfolios of real estate that trade just like stocks on the major exchanges. They own about 15% of the commercial property in the United States. With the low occupancy rates in my town's commercial property market, I wondered if there might be any good bargains in the REIT sector yet.
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The key to making huge, safe gains in REITs comes down to one question. Investors have to ask themselves:
"How much more in dividend payments can I earn in REITs than I can by just placing my money in a risk-free 10-year U.S. Treasury note?"
You see, REITs can become over- and undervalued, just like stocks and private real estate can...
For example, back in 2001, investors didn't care for REITs at all. They just wanted another hot tech stock. REITs as a group were paying dividends of 8.3%, while Treasury notes were only paying 3%. The "spread" between the two assets was huge. Investors had a big incentive to get their money out of risk-free Treasuries and into riskier REITs.
REITs gained more than 250% over the next six years as investors chased the higher yields. Of course, the huge real estate boom that got going in 2003 helped, but you get the idea: When REITs offer high yields versus risk-free Treasury notes, you make a fortune in REITs.
Now... before you get too excited about the possible gains here, remember that REITs can also go the other way... They can become highly overvalued. For instance, in 2007, REITs – which carry the risk of land ownership and stock market volatility – were yielding less than risk-free Treasury bonds.
When REITs are yielding less than safe bonds, you want to lighten – or even eliminate – your REIT holdings.... After REITs reached such low yields in 2007, they fell more than 40% in 10 months. This kind of fall is hardly cushioned by 6% dividend yields.
Bottom line: We want to be heavy buyers of REITs when they offer high yields relative to safe bonds, and we want to lighten up or even avoid them when they offer low yields relative to bonds.
Right now, the Treasury note yields 3.53%. And the National Association of Real Estate Income Trusts Equity REIT index yields 4.99%. The spread is 1.46%.
Below, you'll see a chart showing historical REIT performance in the top pane, and the historical spread between REIT yields and Treasury yields in the bottom pane. (We used NAREIT's equity REIT index to find performance and yield for the REIT sector.)
As you can see, when REIT yields are 2%-3% greater than 10-year Treasury notes (like they were in 2001-2003), REITs are a great deal. When REIT yields are less than those offered by Treasury notes (like they were in 1997 and 2007), it's a sign to exit REITs.
The low occupancy rates in my town tell me must be getting close to bargain territory in commercial real estate. But with a spread of 1.46% over Treasury notes, we’re not there yet. Wait for a 3% spread… and then start buying.
Good investing,
Tom
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