It has been a rough month for REITs. Since the beginning of October the REIT sector has lost about 10%, while the overall S&P 500 index lost about 3%.
Until the month of September, the REIT sector actually outpaced the S&P 500 and even the Brexit vote, which caught the overall market by surprise, hardly affected the sector’s performance.
But the expectations to have an interest rate hike by the end of the year, alongside the uncertainties towards Election Day, led to a severe sell-off in the sector.
The next chart compares the performance of the Vanguard REIT Index ETF (NYSEARCA:VNQ) to the SPDR S&P 500 Trust ETF (SPY) during the recent two years.
It clearly shows that the REIT sector is much more volatile and outperformed the overall market, until a month ago.
What should I do if I bought VNQ at the highs?
Most REIT investors use it as an investment vehicle to produce a constant income. It is essentially a real estate investment without buying an actual property and moreover it delivers a wide diversification across multiple assets.
The recent sell-off in the REIT sector led to a loss on paper to those who bought it at higher prices. But, on the same note, it didn’t have any effect on their expected income flow.
The main problem comes from the fact that we give too much weight to the value of the holding while the main focus should be on the income stability.
Let’s use VNQ as the example.
Throughout the years VNQ paid a growing yearly dividend which exceeded $3 per share in 2015 and is expected to grow even further in 2016.
If an investor bought VNQ at the price range of $90 with a dividend of $3.4 per year, the implied dividend yield for 2016 is 3.8%. It is much better than the alternative 10-year bonds which carry a yield of ~1.8%.
Let’s examine some scenarios for this VNQ investor who bought 100 VNQ shares at a price of $90 and is willing to reinvest the dividends back into the ETF in the next five years.
For the sake of the model’s simplicity, let’s also assume that the yearly dividends remain flat at $3.4 and that the investor is required to pay a 25% tax on the incoming dividends.
In the first scenario, the assumption is that the Fed decides to raise interest rates in December and signals that there would be additional hikes very soon. VNQ price drops by additional 10% to the around $70 where it remains for the following five years.
This is the way to think about the cash flow:
An initial investment of $9,000 generates a net dividend of $340 in the first year. Through the dividends’ reinvestment at a price of $70 per share, the total number of shares accumulated after five years is 119.5 shares, which deliver a net yearly dividend of $303.
The value of the investment after five years is $8,364 as it is calculated using the $70 ETF price.
The second scenario is that for some reason the Fed signals that post-hike it will be very cautious to lift the rate any time soon.
The VNQ price moves upwards to the levels of $100 per share and remains there for the next five years.
Here is the cash flow table using these assumptions:
The reinvestment is done based on a higher ETF price and therefore the accumulation allows to reach 113.4 shares after five years. This holding now generates $287 of net yearly dividend.
The value of the investment is higher at $11,335 as it is based on the $100 price.
The basic human reaction is to find the higher investment value of the second scenario to be more appealing compared to the first one. But in reality, if the goal is to look for an income stream then the dividend flow from the first scenario is higher by 5% compared to the second one.
Naturally, these are two very simple examples but the bottom line is that an investor should define his investment goals and track them through the relevant indicators; if the goal is to achieve capital gains, then the dividends are less relevant to track.
But if it is long-term dividend stream, then the strategy should be accumulation of shares during stressed times, hence the value of the investment shouldn’t be that important.
As a final food for thought, here is a long-term comparison between the REIT sector and the S&P 500 (NYSEARCA:SPY) going from 2004 till 2016. The chart includes the Fed interest rates across time.
As seen from the chart, though it is more volatile, the REIT sector outpaced the overall market during periods of a constant interest rate hike (period 1) and during times of zero interest rate (period 4).
It performed worst during the period of very high interest rate (period 2) and during the period of quick rate drop (period 3).
Could an improving economy signaled by an interest rate hike be good for the REIT business?
The drops in the REIT sector are mostly driven by the uncertainties in the market regarding the presidential elections and the upcoming Fed decision. These times of high anxiety in the markets are good for the long-term investor who is looking to increase his dividend stream.
I suspect that the uncertainties would lead to a continuous sell-off during the next couple of months; therefore define your goals, get your action plan ready and take advantage of the pullback.
I have six REITs within my dividend portfolio which I closely monitor and plan to add to: HCP (NYSE: HCP), National Health Investors (NYSE: NHI), Realty Income (NYSE: O), Omega Healthcare Investors, Inc. (NYSE: OHI), Vanguard REIT ETF and Ventas, Inc. (NYSE: VTR)
I will continue to update the status here in SA.
Disclosure: I am/we are long VNQ, O, VTR, HCP, OHI, NHI.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The opinions of the author are not recommendations to either buy or sell any security. Please do your own research prior to making any investment decision.