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REITs Breakthrough: Real or Bubble?

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Evern among chart-busting performance by the equity market across most indices in recent times, the U.S. REIT industry has outperformed the broader equity market in the first four months of the year, with no signs of slowing.

The year-to-date return for FTSE NAREIT Equity REITs Index is 16.8% (as of May 22, 2013), compared to 14.1% and 13.2% for Dow Jones Industrial Index and S&P 500 Index, respectively. As REITs continue to move north, speculations are rife about whether the uptrend is real or if it's just a bubble. In order to gauge market sentiments, let's dig a little deeper.

REITs as an Asset Class

REITs are a hybrid asset class, offering capital appreciation along with yield, thereby providing more diversification to the equity portfolio with a competitive long-term return. Historically, REITs are considered to have a low correlation with equities, meaning they do not normally move in the same direction as equity stocks or bonds.

More often than not, when stock prices are down, REITs tend to perform better, thus balancing the performance of the overall equity portfolio. Consequently, when broader equity markets were down due to the prolonged economic slowdown, REITs continued their highly successful run.

During the 40-year period from 1972 to 2012, average annual total returns for REITs were 8.09%, while the average annual total return of the industry was 13.72%. In addition, total returns of equity REITs have consistently provided a hedge against inflation. According to the data from Jan 1978 to Mar 2013, total returns of equity REITs have either equaled or exceeded the inflation rate in 67% of high-inflation six-month periods.

The Driving Factors

A combination of factors has helped the listed REIT market to stand out and gain critical mass over the past 15 to 20 years, the most notable among them being a healthy dividend payout. Investors looking for high dividend yields have historically favored the REIT sector.

Solid dividend payouts are arguably the biggest enticement for REIT investors, as U.S. law requires REITs to distribute 90% of their annual taxable income in the form of dividends to shareholders. The dividend yield for the FTSE NAREIT All REITs Index as of May 22, 2013, was 3.93% compared to 2.03% for the 10-year U.S. Treasury Note.

During 2007 to 2009, REITs took on far less debt than private real estate investors, and many were able to sell at the top of the market when private equity investors were still buying. Importantly, during the downturn, REITs were able to acquire properties from highly leveraged investors at deeply discounted prices. This enabled them to add premium high-return assets to their portfolios.

Furthermore, REITs managed to raise capital to pay off debt, owing to a large inflow of funds as institutional investors allocated more ‘dry powder’ to the industry, making them an increasingly attractive investment proposition. In 2012, REITs raised an aggregate of $73.3 billion in capital, which included $45.8 billion in secondary equity common and preferred share offerings, $25.7 billion in unsecured debt offerings and $1.8 billion in initial public offerings.  

Housing Recovery: A Key Strength

The overall housing market is similarly experiencing an uptrend of late. A healthy housing market augurs well for the overall economy and is one of the leading indicators of economic growth.

New home construction is anticipated to have decent momentum in 2013 and is expected to reach to 970,000, up from 780,000 in 2012 and the largest since 2007. Most of these are expected to be driven by multifamily REITs like Avalonbay Communities Inc. (AVB - Free Report) , Equity Residential (EQR - Free Report) , Apartment Investment & Management Co. (AIV - Free Report) , and UDR, Inc. (UDR - Free Report) .

In the first quarter of 2013, U.S. house prices also increased 7.2% – the biggest gain since May 2006, due to job growth and low mortgage rates. This in turn is creating a ripple effect as builders are encouraged to break ground on new projects, while existing homeowners are lured to sell their own properties to buy new ones, taking advantage of low mortgage rates – which are close to the lowest record levels.

According to data from the National Association of Realtors, existing-home sales edged up 0.6% sequentially in Apr 2013 to a seasonally adjusted annual rate of 4.97 million sales, the highest level since Nov 2009.

The Pitfalls

Industry experts believe such astronomical gains are an aberration and not sustainable, implying that the market is due for a correction. With home prices rising faster than income, chances are also high that they are sure to nosedive once investor purchases cool-off.   

The continued adherence to zero-interest policy by the U.S. Federal Reserve have helped the U.S. housing market to stage a recovery from the downturn by attracting new buyers and allowing existing house owners to refinance the mortgages at a low rate. The low interest rates might have also propelled some investors to REITs that offer comparatively high yields.

The real estate market, therefore, is in a Catch-22 situation and only time will tell whether the growth is real or fictitious.

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