Do REITs Have Much Upside Left? (I)

Along with the rest of the real estate market, REITs have been on a tear for the past five years:

(Table shows total returns. Source: NAREIT REIT Watch, December 2004)
http://www.nareit.com/REITWatch/rw0501.pdf

Year: Composite REIT Index, S&P500
1994: 1%, 1%. Even
1995: 18%, 38%. S&P500 ahead by 20%
1996: 36%, 23%. REITs ahead by 13%
1997: 19%, 33%. S&P500 ahead by 14%
1998: -19%, 29%. S&P500 ahead by 48%
1999: -6%, 21%. S&P500 ahead by 27%
2000: 26%, -9%. REITs ahead by 35%
2001: 16%, -12%. REITs ahead by 28%
2002: 5%, -22%. REITs ahead by 27%
2003: 38%, 29%. REITs ahead by 9%
2004: 30%, 11%. REITs ahead by 19%

Splitting the past decade into halves, we have total returns over five-year periods:

1995-1999: REITs +45% (8%/yr.) vs. S&P500 +251% (29%/yr.)
2000-2004: REITs +176% (23%/yr.) vs. S&P500 -11% (-2%/yr.)

The S&P 500 outperformed REITs by 21 percentage points per year during 1995-1999, but this relationship flipped around with REITs outperforming by an even wider margin (25 percentage points per year) during 2000-2004.

For the entire 10 years, REITs win out, though the comparison is more even:

1995-2004: REITs +301% (15%/yr.) vs. S&P500 +213% (12%/yr.)

Another way of looking at REIT performance is to look at the spread between the equity REIT dividend yield and the 10-year constant maturity Treasury yield. During most of the 1990s, the REIT-Treasury spread averaged about 50 bp, though it bounced around quite a bit, ranging all the way from occasional highs of 200 bp to a low of -50 bp. During 1998, around the time of the Long-Term Capital Management hedge fund crisis that drove quality spreads suddenly wider, there was an abrupt "regime change," with the REIT-Treasury spread widening from slightly negative to around 250 bp. For the ensuing five-year period, 1999-2003, the spread fluctuated around a 200 bp average (low 100 bp, high 350 bp). During 2003 and 2004, with interest rates at historical lows (10-year Treasury yield fairly stable around 4% for both years), the REIT-Treasury spread has tightened all the way from 350 bp to the 50 bp range where it sits today (REIT dividend yield 4.6% vs. 10-yr. Treasury 4.1%).

The two conclusions I draw from this historical data are:

1. S&P 500 has more upside than REITs: Since a) equities, whether stocks of "ordinary" companies (proxy: S&P 500 index) or real estate holdings (proxy: REIT index), ought to show similar returns over the long term, and b) REITs have outperformed ordinary stocks for the past five years (reversion to the mean argument), there is a greater likelihood that ordinary stocks will outperform REITs over the next five years.

2. REITs have potential downside: Today's already narrow REIT-Treasury spread is unlikely to narrow substantially more over the next five years, and instead could be driven dramatically wider (along with junk bond spreads that are also very narrow historically) in the event of any "flight to quality" crisis in the bond market. (Comment: By contrast, the stock "fair value" spread (see post dated Jan. 31, 2005) is historically wide, indicating good upside potential for stocks.)

So, aside from certain pockets of opportunity due to special situations in the REIT universe (I'll go into this in a later post), I see ordinary stocks as having a better upside-downside ratio than REITs in today's market.