July 16, 2007
As I come across articles that I think might be of interest, I want to send them along. Not knowing whether or not you have invested in any REITs along the way, I want at least for you to have an awareness of what is occurring in different markets.
So far commercial real estate in America has been immune from the residential housing bust. Commercial real estate prices haven't started falling yet, but that may be starting to change.
The stock market led the way in showing us that residential real estate had peaked, as shares of residential homebuilding companies hit their highs two summers ago. They've lost half their values since.
While shares of residential homebuilders struggled, shares of commercial real estate hardly flinched. They continued higher, peaking early this year.
Their fall has now begun.
The Dow Jones U.S. Real Estate Index – which is significantly made up of commercial property REITs – has fallen about 20% since February. Stock prices can react more quickly than real estate prices, so this fall in the prices of commercial real estate stocks may be a sign of what's around the corner.
Homebuilders Peaked in Mid 2005
Before this drop, this index had risen almost nonstop since the end of the dot-com bubble. Now, shares of commercial real estate companies are ridiculously expensive.
Investors buy REITs for high and rising dividends, and the potential for capital gains. History shows (and it makes sense) that when the dividends of REITs are a lot higher than safe Treasury bonds, it's time to buy REITs.
Back in 2001, you could make a lot more than boring Treasuries. REITs as a group were paying dividends of 8.3%, while Treasury bills were only paying 3%. The spread was huge. So investors had a massive incentive to get their money out of risk-free Treasuries and into riskier REITs.
As you might imagine, REITs performed extremely well over the next few years.
Today, we are in the opposite place. Unbelievably, REITs now pay dividends that are smaller than Treasury bond yields. Looking back over history, when this happened, you couldn't make any money in REITs.
For perspective, we've only been here once before, and the outcome was ugly.
Treasuries yielded more than REITs back in 1997. Once that happened, REITs lost 40% of their values from their peak, with most of that loss coming in the following 12 months. And it took seven years to break even again.
When REITs pay less than 10-year Treasury bonds, like they did in 1997, you lose money in REITs. And when dividends on REITs are significantly more than they are on Treasuries, like they were in 2003, you'll do well in REITs.
The chart below tells the story...
What to Buy, When to Sell
Today, REITs are much more expensive than they were at their 1997 peak. As the chart shows, the spread is much wider today than it was back in 1997.
REITs currently pay the lowest dividend yields in their recorded history. The last time REITs were overvalued, in 1997, they paid 6% interest. Today, they pay less than 4%.
Residential real estate peaked in the summer of 2005 and has been weakening since. Commercial real estate shares are next, and shares of REITs are overpriced, with plenty of room to fall.
Currently we hold shares in several REIT funds which are paying us a very attractive yield. But don't be surprised if you see our share prices move downward. The important thing to remember is that these funds are to be held over the long term and like everything else, the pendulum swings back and forth. Eventually the residential market will revive. An article I was recently reading is how attractive US real estate has become for foreigners. With the dollar so weak and the euro and other currencies so strong, US real estate is a bargain. Recently an apartment in London was sold for $334,000. Doesn't sound like too much until you see that it was only 77 sq. feet!!! No running water or a bathroom and only the size of a closet!!! Incredible. There are already 1.3 million people from England that own real estate in Florida. In New York City, foreigners are flooding in. All of the US is in the bargain bin for them. So maybe, the rest of the world will eventually suck up a lot of our real estate and we'll see prices moving up again.
Hope you're having a good day.
Pete Lipke