Why It's Time to Buy REITs

Just a few weeks ago, I introduced my new theory of "The Great Re-Leveraging" to readers of my investment advisory. 

What is the Great Re-Leveraging? And how is it going to hand investors 60% in the next six months? 

It all comes down to what's called an interest rate spread. This is a critical concept for investors to understand... 

The constant devaluation of the U.S. dollar via inflation makes it difficult to measure asset prices over time. For example, gas is really much cheaper today (at $2) than it was 10 years ago (when it cost $1.50). That's because the purchasing power of the dollar has fallen by about 50% over the last 10 years. (And it's about to fall a lot more...) 

Inflation makes it difficult to judge the relative value of financial assets. That's why financial analysts spend so much time talking about various ratios – like the price-to-earnings and price-to-book ratios. These ratios are much better measures of value than nominal prices because nominal prices change with inflation. Ratios don't. 

The most important ratio for REITs is the ratio between the dividend yield investors can earn from REITs and the interest they can earn on a "risk-free" Treasury bond. Most investors buy REITs for income. So the Treasury-bond yield heavily influences the prices of REITs. If you could get 10% annually from Treasury bonds, you wouldn't accept the risk of owning a REIT unless you could get at least three or four percentage points more from it. These extra percentage points of income are the "spread." 

 

The chart above shows the spread, in percentage points, between the dividend yield of REITs (measured by the DJ REIT index) versus the yield on a 10-year U.S. government bond. 

As you can see, most of the time, investors demand a premium of between two and four percentage points compared to Treasuries. But... from time to time... investors become enamored with real estate. During 2006 and 2007, investors would have actually made more money investing in U.S. Treasuries than in REITs. That was a huge warning sign that real estate was extremely overvalued. 

On the other hand, we'd never seen investors demanding such a large premium over Treasury yields to buy REITs as we saw in early March. Investors wanted more than 7% annually on top of Treasury-bond yields to own REITs. That's the widest spread of all time. 

While it's possible for conditions in real estate to get worse and for investors to demand still more premium in the future, I think we've likely seen the peak of the REIT spread. And that means REIT share prices are likely to continue rallying. 

Why do I think the bear market in REITs is over? Because the floodgates of new capital have opened. 

In March, Simon Property, the nation's largest publicly traded REIT, was desperate to raise new capital to fund operations. It raised $500 million by selling stock – at $31 per share. That offering was only the second time any REIT had been able to raise new equity during 2009. 

But since then, many other REITs have followed. Several billion dollars has been raised in only the last month. This move of capital back into real estate has caused REIT prices to rebound and the REIT spread over Treasuries to decline for the first time since mid-2007. 

Sentiment and access to capital play a huge role in real estate prices. The more capital that's available, the higher prices will move. The higher prices move, the more capital becomes available – because there's more collateral. Sentiment is incredibly important to these markets. It opens the flow of new capital. And sentiment is now completely different than it was in March. 

Simon Property recently announced another equity offering – this time $800 million in new equity. You might expect the market to react warily because these new shares will dilute the existing shareholders. But instead, the stock rallied – almost 10%. The reaction was so strong, the company was able to increase both the price and the amount of the offering – raising $1 billion at $50 per share. 

The fact that REITs have this kind of access to capital tells me the yield spread has peaked and it's time to buy REITs. 

Good investing, 

Porter Stansberry