1/12/2017 | By Brad Case
The beginning of a new year is as good a time as any for a summary of “where we stand” in the market for equity real estate investment returns. Over the next several days I’ll publish a series of market commentaries on several items of information that are important for making real estate investment decisions, starting with a look today at total returns.
The Exchange-Traded REIT Market
The FTSE NAREIT All REIT index finished 2016 with a total return of +9.28%. That may sound good, but it’s weak by the standards of exchange-traded REITs: since the end of 1990 (roughly the “modern REIT era”) total returns have been stronger than +9.28% during 15 calendar years and weaker during only 10 calendar years. (Going back as far as data allow, to the beginning of 1972, shows 26 calendar years of returns stronger than +9.28% compared to just 18 years of weaker returns.) Long-term compound average total returns for exchange-traded REITs have been +11.45% over the 26 years since the end of 1990, compared to 7.43% per year over the 16 years of available data from the “pre-modern era.”
The REIT market has two major components, Equity REITs and Mortgage REITs. Equity REITs, which own physical real estate assets (mainly buildings), comprised more than ninety-four percent of the total market at the end of 2016, while mortgage REITs, which own real estate debt (mainly mortgages and mortgage-backed securities), comprised less than six percent. Both are part of the real estate asset class, but their business models and return drivers differ somewhat, and they seem to have different investor bases: mortgage REITs appeal strongly to individual investors, perhaps because of their typically much higher dividend yields, while institutional investors seem to focus more on equity REITs, perhaps because they compete directly (and successfully) with institutional holdings of illiquid equity real estate including direct property ownership and private equity real estate funds.
The smaller part of the REIT market was the superior performer during 2016: the FTSE NAREIT Mortgage REIT index finished 2016 with a total return of +22.85%. That sounds stunningly good, so it may surprise you that returns that strong are not exactly rare for mortgage REITs, at least during the modern REIT era. In fact, over the preceding 25 years there have actually been seven—that is, more than one-quarter—in which mortgage REITs bested that figure: 1991 (+31.83%), 1995 (+63.42%), 1996 (+50.86%), 2001 (+77.35%), 2002 (+31.08%), 2003 (+57.39%), and 2009 (24.63%); in addition, returns during 2010 very nearly equaled it at +22.60%. Long-term compound average total returns for exchange-traded Mortgage REITs have been 7.10% over the 26 years of the modern REIT era, compared to a much weaker 2.80% per year over the 19 years prior to that.
The larger part of the REIT market was the weaker performer during 2016: the FTSE NAREIT All Equity REIT index finished 2016 with a total return of +8.63%. Again, that may sound good, but it’s weak by the standards of exchange-traded Equity REITs: since the end of 1990 total returns have been stronger than +8.63% during 16 years and weaker during only nine years. (Going back as far as data allow, to the beginning of 1972, shows 29 years of stronger returns compared to just 15 years of weaker returns.) Long-term compound average total returns for exchange-traded Equity REITs have been amazingly consistent at 11.98% over the 26 years since the end of 1990, 11.85% over the 19 years prior to that, and 11.93% over the full 45-year period since data started being kept at the end of 1971.
REITs compared to the Broad Stock Market
The big winners during 2016 were small- and mid-cap stocks, especially small- and mid-cap value stocks: the Russell 2000 Value index, for example, posted a total return of +31.74% on the year (much of it coming during just the month of November), which is the seventh-largest annual gain ever recorded for the R2000V and the fifth-largest since the beginning of the modern REIT era. (In other words, 2016’s performance was more of an outlier for small-cap value stocks than it was for mortgage REITs.) As a result, small-cap value and mid-cap value finally became the only stock categories to have outperformed REITs over the duration of the modern REIT era. (Of course many REITs are also included in the broad small-cap value and mid-cap value indices.)
Over the past 26 years exchange-traded Equity REITs have outgained large-cap stocks (10.13% per year according to the Russell 1000), small-cap stocks (10.90% according to the Russell 2000), growth stocks (9.18% according to the Russell 3000 Growth), value stocks (10.69% according to the Russell 3000 Value), Information Technology stocks (11.18% according to the S&P 500 Info Tech Sector Index), Health Care and Consumer Discretionary stocks (11.13% each), Consumer Staples (10.74%), Energy stocks (10.12%), Financials (10.10%--including the healthy contribution the Financial sector received during the 25½ years while Equity REITs were part of it!), Materials stocks (8.56%), Utilities (8.36%), and Telecommunications Services (6.99%). To put some of those figures into perspective, an initial investment of $1,000 at the end of 1990 would have grown to $18,967 if invested in the stocks comprising the FTSE NAREIT All Equity REIT Index (ignoring fees) compared to just $11,638 if invested in the stocks of the S&P 500 Index, $15,714 if invested in the S&P 500 Info Tech sector, $12,202 if invested in the S&P 500 Financial sector, or $8,057 if invested in the stocks of the S&P 500 Utilities sector.
REITs compared to Illiquid Real Estate
Every single empirical study that has compared the net total returns of exchange-traded Equity REITs with those of illiquid investments in equity real estate has reached the same conclusion: REIT-owned property returns (that is, unlevered asset-level returns) appear to have been slightly better than non-REIT-owned property returns regardless of the time period studied. Unfortunately we won’t have a handle on returns in the illiquid real estate market for a while yet: returns aren’t reported until at least 4 weeks after the end of each quarter, never mind the lag averaging approximately four quarters in measuring them. Keeping in mind that caveat, the most recent figures for the NCREIF Property Index published by the National Council of Real Estate Investment Fiduciaries measured gross total returns averaging 6.13% for the first three quarters of the year, corresponding to net total returns of about 5.35%; NCREIF’s ODCE index measured net total returns of open-end diversified core private equity real estate funds (using leverage averaging about 22%, or about two-thirds of the leverage held by exchange-traded equity REITs) at 5.80% over the same three quarters. Both performances were easily bested by exchange-traded Equity REITs, whose gross total returns would translate to net total returns averaging about 11.89% over the first three quarters (and 8.08% over the full year) assuming the average institutional investor’s investment costs.
In short, a below-standard year for exchange-traded Equity REITs was still better than their counterparts in the illiquid real estate market, while a stunningly successful year for exchange-traded Mortgage REITs wasn’t all that out of the ordinary.