The yield of an asset is a key component of predicting future returns. This is true for the yield on Treasury bonds as well as the dividend yield for stock indexes. The yield on aggregate bond indexes is considered a good proxy for future expected returns. The dividend yield of broad stock indexes has been shown to provide significant value in predicting future stock index returns. In both cases, low yields tend to predict high future returns, and vice versa. These arguments that yields predict returns are not without critics, especially for equities.
In an interesting twist on this type of analysis, Bill Bernstein recently noted that yields on equity REITs appear to have substantial value in predicting future real returns. I was not surprised by his findings overall, but his analysis is very compelling and suggests that the relationship between REIT yields and future returns is, in fact, even more robust than I would have imagined. I was so struck by his analysis that I asked if I might reproduce his chart in a blog post and he kindly gave me permission. Here is his chart:
This chart uses monthly data, from the end of 1971 through August of 2012, so each point compares the yield on equity REITs to the total return over the next five years, net of inflation. The inflation measure is the CPI (Consumer Price Index). These data suggest that the current yield on equity REITs explains 40% of the future variability in total return (R^2 of the trend line is 40%).
Using this relationship, Bernstein concludes that even in the rosiest outcome, we should expect REITs to deliver no more than 1.4% per year, net of inflation, over the next five years. Given that REITs have historical volatility levels not much below equities, this low a return is not at all attractive. This type of projection is, of course, subject to a vast range of uncertainties but it is certainly food for thought.
Even without going beyond the data explicitly reflected in the chart, there is a lot to think through. There are a number of ETFs and index funds that track U.S. equity REIT indexes, including VNQ (Vanguard), ICF (iShares), and a range of others. The trailing 12-month yield for VNQ is currently 3.15% and for ICF the corresponding yield is 2.67%. Based on the 41-year data sample in Bernstein’s chart, it is very hard to see how we could end up with positive real returns over the next five years, given these yields.
Perhaps the largest lesson to draw from this chart, as well as from other studies that show a persistent relationship between yield and future returns on various asset classes, is simply that markets swing broadly around fundamental relationships. It is hard to be a contrarian. The last real estate bubble should be vivid enough to remind us to consider the lessons of both history and fundamentals, but apparently this is not the case. In the last bubble, people convinced themselves that real estate was a good bet because this asset class had delivered outsized returns for a number of years. The recent run-up in real estate prices is more the result of Fed policy and investors seeking yield in a low-rate environment. The fundamental drivers, however, remain the same. The past, as they say, does not repeat, but it does rhyme. The implication of current REIT yields is that expected future return is low.
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