Questions emerge as REIT rally hits year three
By Murray Coleman
(This article was originally published Thursday.)
--REIT valuations are seen as rather rich for the real-estate sector
--Following a rise in correlation last year, REITs and S&P 500 may be starting to break out of lockstep
--Some advisers say REIT ETFs are still a good way to diversify portfolios
SAN FRANCISCO (MarketWatch) -- As commercial real estate enters a third year of recovery, exchange-traded funds focusing on that corner of the market seem to be losing some of their appeal.
Not only are relative valuations looking stretched, but real-estate-investment trusts have been moving more in lockstep with blue-chip stocks. A rise in correlation last year between REITs and the Standard & Poor's 500 Index is raising questions about their diversification benefits to long-term investors.
During the most recent financial crisis, REITs fell just as hard as the SPDR S&P 500 (NAR:SPY) , which tracks the index bearing its name. The most liquid ETF among REITs, the iShares Dow Jones U.S. Real Estate Index Fund (NAR:IYR) , slid almost 40% in 2008. SPY, the industry's biggest ETF in terms of assets, dropped nearly 37% that year.
When markets started rallying, REITs took off as well. Since early March 2009, IYR's shares have more than tripled. In that same period, SPY had more than doubled through Wednesday.
Since yields move inversely to prices, the IYR's outperformance has resulted in a shrinking in its distribution yield to around 4%. While that is almost double the payout for the iShares Barclays 7-10 Year Treasury Bond Fund (NAR:IEF) , such a yield still represents a drop from its 20-year average yield of 6.5%, as tracked by the FTSE NAREIT Composite REITs Index.
The advance by REITs also has made the sector appear rather pricey by some measures. The 12-month trailing price-earnings ratio for the S&P 500 is around 13.9, down from its average since 1996 of 19.5, according to Sage Advisory Services. At the same time, the firm estimated, REITs were trading at a 19.4 price-to-funds-from-operations multiple, a financial metric for such real-estate firms. By comparison, the category's long-term average was about 14.5.
"You've got to really like commercial real estate to buy them at this point in the cycle," said Rob Williams, the Austin, Texas, advisory firm's research director.
An expanding chorus of analysts has been sounding cautionary notes that REIT funds aren't providing as much diversification as in the past. At issue are correlation rates, which compare directional performance trends of specific funds against the broader market. A month ago, the popular IYR was at 83 on a scale in which 100 represents equal tandem with the S&P 500.
But correlations tend to ebb and flow over time, noted Mark Armbruster, an adviser based in Rochester, N.Y. He said the benchmark underlying IYR has bounced over longer periods from a correlation in the 50s to a 90-plus level.
Along those lines, the iShares REIT fund has started showing signs of returning to more traditional levels. Earlier this week, ConvergEx Group estimated IYR's correlation had dropped to 58 in the past 30 trading days.
Armbruster, who is president of Armbruster Capital Management, said while he isn't adding to existing positions, REITs remain a core allocation in client portfolios.
"Everything went down together and now everything's basically recovering together," Armbruster said. "But we believe that the economic drivers for commercial real estate are unique enough so that the historical diversification benefits of holding REITs will return over time."
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