Are REITs A Practical Bond Alternative?

REITOnce thought of as a quintessential investment, residential real estate has lost a lot of its allure over the past decade. Indeed, the economy is still working off the excesses brought about by the housing bubble and subsequent fiscal crisis. As a result, the “safe” 8-10% annual appreciation that a home or property owner could count on in decades past has, in most markets, turned into something a lot less robust and far less reliable. If one was unlucky enough to buy real estate in overheated markets at the top of the bubble, the American dream of home ownership has turned disastrous.

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Still, the real estate milieu is about much more than the residential housing market. It is about stand alone commercial and industrial properties, shopping malls and strip centers, self storage facilities, and data centers. It is about companies that buy and sell real estate and lease properties to tenants. Real estate investment trusts, or REITs for short, were created many decades ago in an effort to afford investors the opportunity to expose themselves to the growth and income opportunities inherent in the real estate business.

Today, there are over 100 publicly traded REITs that investors can invest in ranging from names like Simon Property Group (SPG), the nation’s largest operator of malls with a current yield of 3.2%, to Realty Income (O) with yield of 5.3%, which leases thousands of stand alone commercial properties to hundreds of tenants and pays shareholders a monthly dividend based primarily on the performance of its cash flows. REITs are essentially a packaged pool of real estate assets similar to a mutual fund. And since REITs by law must pay out 90% of taxable income to shareholders, in general, REITs can be looked upon, similar to bonds, as a reliable source income stream.

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Unlike a bond, however, there is no contractual guarantee associated with a REIT. Since REIT shares trade on the open market and are exposed to the whims of individual investors, trading can at times be volatile. During the fiscal crisis back in ’09, many REITs were forced to cut or discontinue their dividends due to their dependency on capital markets and banks for growth and liquidity needs. Though the financial markets of today are far more stable than five years ago, this is certainly a downside that investors need consider.

Further, REITs such as Simon and Realty Income should not be confused with mortgage REITs, or mREITs for short. Mortgage REITs typically buy and sell mortgage-backed securities (MBS) on a highly leveraged basis and while they typically yield more, they are considered much more risky than REITs that invest in and operate brick and mortar properties.

The Recent Symmetry Of Bonds And REITs

In 2013, a year in which most stocks did quite well, REITs by and large performed rather poorly. Due to the perception that REITs will suffer in a rising interest rate climate, the sector slumped following the Fed’s announcement that it would begin to taper its stimulative bond buying purchases. If you examine the below chart, you will see that REITs as measured by iShares index IYR (blue line) sold off precipitously starting late May through the summer of ’13. The blue line in the chart measures the performance of TLT, a long-term Treasury index ETF. The similarity is not a coincidence.

Investors, for better or worse, have started to trade REITs basically in line with long bonds. You can see in the far right quadrant of our graph, despite the general stock market sell off in January, REITs and bonds performed quite well.

Despite this symmetry, I would caution that it is something that might or might not continue. As was mentioned previously, although the dependability of their cash flows may be similar, REITs are stocks, not bonds. Should real estate fundamentals change, whereby there is a noticeable appreciation (or depreciation) in general real estate valuations, significant capital performance divergence could take place.

Should You Use REITs in Place of Bonds?

Since investors can find comparable yields in both products, the temptation may be there to shift bond exposure towards REITs, especially since the latter also tends to grow its yield over time. However, the capital risk of REITs remains unquestionably elevated relative to the contractual guarantee of a bond.

Still, I think REITs make sense for the average income investor looking for a dependable yield. So for most investors, I don’t think REITs should be viewed necessarily as an alternative to a bond, but more so as a potential enhancement and diversification element within a somewhat risk tolerant income portfolio.

About the author:

aloisiAdam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.

 

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