Are REITs a Buy?

Buy low, sell high.  Sounds easy, right?  Apparently not.  The Real Estate Investment Trust (REIT) sector experienced net fund outflows of $7.1 billion in 2007, a sector that had previously been as hot as any in recent history.  Meanwhile, Vanguard’s REIT Index ETF (VNQ), the ETF version of my REIT fund of choice, dropped 16.4% for the year on recession fears due to last summer’s credit crunch, driving historically-low dividend yields back up to moderate levels.   In fact, the spread between REIT yields and the 10-year Treasury has climbed back to its highest level since early spring 2004 at around 1.2%.

While nobody expects the next five years to be as kind to REITs as the last five, it looks as though REIT valuations are finally reverting to near their long-term average of about 17 times Funds From Operations (FFO).  Add the current dividend yield of about 5% to REITs’ long-term average FFO growth rate of 5-6% per year and you have a long-term future expected return of about 10-11% per year, a return few people would complain about.  And yet, pessimism for this asset class is still high.  In a post today on one of my favorite personal finance blogs, Free Money Finance’s guest columnist advises investors to avoid Real Estate Investment Trusts based on what seems like nothing more than unsustainable recent returns and vague concerns of future broad economic troubles.  If there is one thing I’ve learned, it’s that predicting the future, especially in the short term, is nearly impossible.  For long-term investors with a decades-long time horizon, I see no reason to either cut back or hold off on adding to an established REIT stake, especially considering today’s moderate valuations and solid long-term return potential.  I’m not saying REITs won’t fall further or that they will experience another bull market soon, but what I AM saying is that for the long-term investor, it doesn’t matter.

Over the long term, commercial real estate will continue to provide adequate returns for the risks involved.  REITs continue to be only weakly correlated with the broad US Stock Market (with a trailing 36 month R-squared of 34) and thus a good diversifier in a multi-asset-class long-term portfolio.  As you may know, I maintain a 10% REIT stake in my Roth IRA as part of my long-term asset allocation.  I will stay the course and continue rebalancing annually to force myself to buy low and sell high year in and year out because I’m not smart enough to time the market.  Are you staying the course?   Buying?  Selling?  Why or why not?