Rising rates, or as Jim Grant says, “Interest rates we can be proud of,” considerably change investment decision calculus. Regardless of whether the subject is equity, fixed income, or private investment opportunities, investments can be evaluated using the basic bond math inputs: Yield, Credit, Duration, and Convexity. Yield is what you will get paid, credit is if you will get paid, duration is when you will get paid, and convexity considers “how” you might get paid, either through income or capital appreciation as it relates to changes in interest rates. If this is a bit obtuse, don’t worry; I will focus on yield, the simplest of these inputs, and REIT dividend yields specifically.
Because such a substantial portion of REIT returns comes from income, the going-in cash yield of REITs is an undeniably important consideration for investors. Since 2014, over 70% of the total return of REITs has come from dividends.
Over that period, dividends grew by roughly 3% per year, while payout ratios, as measured against Funds from Operation, stayed relatively flat in the 60-75% range. By these measures, REITs have lived up to their defensive reputation in portfolios, even as the broader market focused on the inflating terminal values of tech companies who eschewed any cash shareholder returns. Today, rising real rates have made money dearer; as a result, cash returns are again coming into vogue.
However, when viewed against the yields available on 10-year US Treasuries, REIT dividend yields are at the widest negative spread in the past decade. On average, the capitalization-weighted REIT index has provided a dividend yield 166 basis points wide of the 10-Year Treasury. Today, that spread is 100 basis points to the negative.
The annualized dividend of IYR 0.00%↑ is 2.24% versus 4.4% available via the safety of the US government benchmark. If shown only this metric, most investors would reasonably assume REITs were overvalued. Surely, an investment whose returns are so reliant on income must offer a higher yield than the risk-free alternative. However, such a view would be overly simplistic when evaluating the overall opportunity in REITs.
REITs have a mandated return of shareholder capital to maintain their tax status. 90% of taxable REIT income must be distributed. While this taxable income benefits from a sizable depreciation shield, REITs still pay out roughly 70% of their cash flow. That cash flow grows by the levered return on their investments. On a capitalization-weighted basis, REITs have grown dividends by around 5% over the past 5 years, while the top 20 market capitalization REITs have grown their dividends by over 8%.
