Some questions and comments popped up about REITs since I introduced the table on asset class returns – why did REITs perform so well the last 15 years? Others saw REITs on top eight out of fifteen years and concluded it must be the best investment going forward (despite me pointing out the failings of that conclusion). I thought I’d find the answer.
From ’00 to ’14, REITs blew away other asset classes with a 12.9% annual return. Before you start drooling over that number, remember how REITs work. While you get those juicy returns, you also get the tax consequences.
REITs avoid a big chunk of corporate taxes by paying out most of its income through dividends. In return, REITs have their own tax rules which are passed down to you (dividends are taxed as ordinary income).
Taxes aside, the great REIT performance boils down to investor behavior, changing tides, and Fed influence:
- REITs avoided the dotcom crash
- Reinvested dividends
- Falling interest rates
- Relatively quick real estate recovery
All four of these played a role in the performance. I’m sure there are others, but this is what I consider the most important. I’d like to focus mainly on dividends and falling interest rates.
In the late ’90s, everyone wanted tech stocks. Nobody was buying REITs when anything “.com” could get 1000% returns. REITs were mostly ignored during the Dotcom boom.
But then the crash hit. Growth was done. Safety was in.
Everyone wanted “safer” income producing assets like bonds, utilities, and REITs. And REITs paid a great dividend back then – about 8% yield in 2000 compared to 3.5% now.
Let’s get this out of the way first. The asset class table shows total returns for all assets – dividends are reinvested. This makes comparisons easier. I’d bet most investors reinvest whether they know it or not. Combining consistently high dividends with the power of compounding gets you solid long-term results.
When you compare the total return (with reinvested dividends) to the price return (no dividends), you get a picture of why REITs performed so well. The table below shows how much dividends impact REIT returns and what drove performance since 2000:
|Year||Total Return||Price Return||Difference|
*YTD is up to 6/30/14. The FTSE NAREIT Index started in 1972. You can find the data here.
A couple of things quickly stand out:
- Total returns didn’t change much compared to the historical return
- Dividends make up a smaller piece of the total returns
Dividend yields fall for one of two reasons: either share price rises or dividend payout falls. I don’t have stats on dividend payout for each year, but looking at the price returns over that period versus historically, rising prices had an impact. Put another way, rising prices drove a larger part of the total return compared to the historical norm.
But what drove higher prices? How much longer do you think that will last?
Falling Interest Rates
As interest rates rise and fall, income investors move money to different assets based on the risk and yield they get – always on the search for lower risk, higher returns.
When rates on bonds fell, investors scrambled for a better yield – into dividend stocks, preferred stocks, junk bonds, and REITs. Since ’09, anything paying a dividend has seen its price rise. Again, there’s only two ways to lower dividend yields – lower the payout or raise the price. Simply, investors wanted yield. They paid more money for a dollar of yield than in 2000.
Except, REITs get riskier when yields fall too low. Nobody will pay for low REIT yields once lower risk bonds become a competitive option again. When that happens, REIT prices and yields will revert to more historic levels.
If you’re looking at the table thinking REITs are a great investment due to its past greatness, think again. Nothing lasts forever.