Saturday, June 1, 2013

Bond Servants: REITs Under the Lash of the Bond Market

NAREIT starts its annual investor conference this coming week. Until a few weeks ago it was going to be a celebration of the near 20% gain posted by the RMZ Index as of May 21. Since then the world became a very hostile place for REITs with the RMZ declining from 1070 to 969 as of Friday's close, a drop of 9.4%. To be sure REITs are still up 8% for the year, which would normally be a cause for celebration, but not this week.

Although most REIT investors paid lip service to the fact that very low bond yields acted as a tailwind behind the REIT bull market, most of them were caught by complete surprise as to how powerful the negative effect of the 50 basis point backup in 10-year U.S. Treasury yields to 2.16% that occurred in the month of May would be.

My sense is that the back-up in yields is just beginning. Although I do not believe that it will be dramatic as the last few weeks, it would not surprise me to see the 10-year treasury yielding 2.5% at yearend and in excess of 3.5% by the end of 2014. As a result the bond market will become a major headwind in front of REIT share prices.

If REITs were inexpensive, the benefits of a growing economy would work to offset some or all of the negative effects coming from higher interest rates. Unfortunately that is not the case. With REITs trading at around 20X EBITDA they are far from being attractively priced. The true test will come from the private market where it is way too soon to see if cap rates have been affected by the the back-up in rates. If the past is any guide it will take awhile because there is way too much investor intertia in this market, especially where public pension plans are concerned. Thus the effects of rising rates on the private market probably will not be visisble until the Fall.

In the meantime the joys of being a bond substitute will give way to sorrows. As a result selling the rallies might very well be a better strategy than buying the dips.

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