The domestic real estate investment trust sector does not yet, on average, offer enough of a yield advantage over risk-free government bonds to suggest strong returns for the coming years, according to an analysis I’ve conducted of the past 18 years of data.
There are many ways that individual REITs can generate solid returns. These include increasing distributions in a sustainable way, effective and timely property investment, capitalizing on subindustry-specific trends, and raising funds from operations per unit (FFOPU, the industry version of cash flow).
For the REIT sector as a whole, however, future returns are often determined by the extent to which distribution yields exceed Government of Canada five-year bond yields. The accompanying chart, using the past 18 years of S&P/TSX REIT Index returns (the maximum available), outlines the trend.
Each dot on the chart represents a month-end REIT yield spread – the indicated distribution yield of REITs minus the yield on the government bond on the X-axis – and the performance of the REIT index during the following 24 months on Y-axis.
For instance, the dot furthest to the right plots a happy instance (it was February, 2009), when the yield spread was 9.91 per cent and the REIT index returned 93.9 per cent in the next 24 months, without distributions.
The consistent grouping of the dots around a trendline moving up and to the right implies strongly that returns usually climb as the yield spread rises.
The current distribution on the REIT index is 6.2 per cent and the five-year bond yield is 3.6 per cent. This makes the yield spread 2.6 percentage points.
We can find roughly 2.6 percentage points on the X-axis. The dots in that range intersect the Y-axis (which measures future returns) at points ranging from minus 36.3 per cent to positive 20 per cent, providing investors with a broad frame of reference for two-year returns for the benchmark from here. It is relevant, however, that the bulk of returns near 2.6 percentage points on the X-axis have been in flat-to-negative territory before distributions.
Past performance trends do not – as the caveat goes – guarantee future returns, even if we don’t have a lot else to go with. I also want to reiterate that there will almost certainly be individual REITs that move counter to the trend. The outlook for different areas of the real estate market, from multiunit residential, industrial to senior living, vary widely.
But investors should be extra-selective in buying REITs, verifying cash flow growth prospects, when the aggregate distribution yield is below the 3.5-per-cent to 4-per-cent range that more strongly suggest positive predistribution returns.
Scott Barlow is a market strategist for The Globe and Mail.
Scott Barlow