The recent sell-off in the domestic real estate investment trust sector is way overdone based on the yield advantage over government bonds. The 10-year performance history of the market segment suggests an average annual return above 10 per cent for the next two years.
Fears that rising bond yields would attract investor funds away from the real estate sector have seen the S&P/TSX REIT index fall 12.3 per cent since July 12. The average distribution yield in the sector, however, remains more than five percentage points above the government of Canada five-year bond yield, a level that suggests strong returns for REIT investors for the next two years.
The charts below represent two different ways of showing the REIT sector's yield advantage – the indicated yield on the S&P/TSX REIT index minus the yield on the five-year bond – and its historical impact on performance during the ensuing 24 months.
Each diamond on the scatter chart represents the REIT index's yield differential over bonds and forward two-year cumulative return for every week in the past 10 years. The furthest data point to the right on the chart, for example, shows a week when the yield differential between REITs and bonds was 11.03 per cent, and this was followed by a two-year period when the REIT index generated a 98.4 per cent return. (Dates are not used on these types of charts – we're looking for performance patterns, not market timing – but for interest's sake I can note the yield data for the point cited as an example above are from the week ended Nov. 21, 2008, and index performance between November, 2008 and November, 2010).
The upward sloping trend line indicates that the larger the yield advantage enjoyed by REITs relative to bonds (the x-axis), the higher the returns have been (y-axis). Currently, the indicated yield on the S&P/TSX REIT index is 6 per cent, and the five-year bond is yielding 0.99 per cent. This gives a yield advantage of just over five percentage points.
Looking at where the trend line hits 5 per cent on the x-axis, and following this intersection point to the y-axis, this suggests a two-year forward cumulative return of about 20 per cent. Note that this is a simple return projection – not including distribution yield.
I included a line chart with the same analysis for clarity's sake. The grey line shows the REIT yield minus the five-year government bond yield, and the orange line shows the S&P/TSX REIT index forward two-year return performance after that point. For example, the first data points indicate that on Dec. 1, 2006, REITs yielded 1.56 per cent more than government bonds, and the index dropped 54 per cent in the next 24 months during the financial crisis.
The same pattern holds – the bigger the REIT yield advantage over bonds (the higher the grey line goes) – the stronger the ensuing performance for the sector.
This is all very encouraging for investors in the real estate sector but, as always, there are no guarantees in markets. Yield differential is not the only performance driver and other factors, like the asset value writedowns we've seen from Alberta-based REITs, can get in the way. Still, history indicates that the current relative yield situation paints a very positive picture for investors.