Are REITs Now Undervalued?
September 8, 2009
by Geoff Considine, Ph.D.
My analysis with Monte Carlo simulations over the years prior to the 2008 collapse in REITs increasingly emphasized the third item as the dominant consideration. From a strategic standpoint, REITs are an important asset class because of their historically-low correlations to equities. From a tactical standpoint, the trailing returns from REITs were far higher than could be justified on any rational basis—the REIT market was clearly a bubble. In March 2007, my Monte Carlo analysis suggested that REITs were vastly over-valued. By November 2007, REITs had declined substantially, but a fresh analysis still indicated substantial overvaluation.
The next part of the story is well-known: the major decline in all asset classes in 2008-2009 included major additional declines in REITs, with 2008 being a watershed year. VGSIX lost 27% (after losing 16.5% in 2007), ICF lost 41% (after losing 18.3% in 2007), and RWR lost 38.7% (after losing 17.8% in 2007). These returns may be compared to the 37% loss suffered in 2008 by the S&P500, which had posted a 5% gain in 2007.
After two years of steep decline in REITs, the trailing three years statistics look very different than they did in July 2006:
The trailing three-year returns for the REIT funds we considered above are now substantially in the red—far worse than those of the major equity classes. The trailing volatility has remained at about twice that of the S&P500. Volatility across all of these funds has roughly doubled (although the increase is somewhat muted for small caps). The across-the-board increase in volatility for all asset classes was expected (see here), but what is most surprising in the above results is that Betas now indicate that REITs ceased to have a muting effect on moves in the S&P500; they actually amplified market swings during the last several years.
While the correlations between the REIT index funds and the major equity classes did not exceed 50% in July 2006, they now range from 79% to 90%. This dramatic increase in correlations means that REITs are currently providing far lower diversification value than they have historically.
Strategic asset allocation is the process of combining assets that provide positive diversification effects. Tactical asset allocation is the process of allocating to exploit relatively near-term mis-pricing among assets. With the trailing average returns of REITs very low and their correlations very high, tactical considerations dominate strategic considerations in the current environment.
Variability among REITs and key warning variables
One of the most striking features of the REIT market is the enormous disparity in Betas, volatilities, and correlations to major asset classes among different REIT assets. REITs are often treated as a monolithic asset class, but they are not. REITs can perform very differently from one another.
I divided the largest REITs into three classes: Diversified, Healthcare Facilities, and Residential:
For the three-year period through July 2009, a number of features stand out. First, we see that there is enormous variability among REITs in terms of Beta and total volatility. This variability is evident within each of the three classes. There is a huge difference between the portfolio impacts of a REIT with a Beta of 2.00+ and one with a Beta of 1.00. Similarly, there is a major difference between the portfolio impacts of a REIT with 30% volatility and one with a 50% or more volatility.