Low Treasury yields may help US REITs to outperform - Capital Economics
Asset Allocation

Low Treasury yields may help US REITs to outperform

Asset Allocation Update
Written by Oliver Allen

US equity real estate investment trusts (REITs) have underperformed ordinary US equities considerably in 2020 despite a plunge in US Treasury yields, which usually provides more of a boost to the former than the latter. However, we expect US REITs to outperform over the next few years, as the US economy recovers from its coronavirus-induced slump, and Treasury yields remained well-anchored by Fed policy.

  • US equity real estate investment trusts (REITs) have underperformed ordinary US equities considerably in 2020 despite a plunge in US Treasury yields, which usually provides more of a boost to the former than the latter. However, we expect US REITs to outperform over the next few years, as the US economy recovers from its coronavirus-induced slump, and Treasury yields remained well-anchored by Fed policy.
  • The dividend yield of the FTSE Nareit Equity REITs index has consistently been higher than that of the S&P 500 since 2000. (See Chart 1.) This is presumably because REITs must pay out at least 90% of their taxable income as dividends. What’s more, these income streams are usually quite stable due to fixed-length rental contracts. As a result, US REITs are arguably a closer substitute than ordinary US equities for bonds.
  • This probably helps to explain the fairly good relationship over the past two decades between the 10-year US Treasury yield and the performance of US REITs relative to ordinary US equities. (See Chart 2.)
  • However, there has been a big break in this relationship in 2020, as any boost to the relative performance of US REITs from this year’s plunge in Treasury yields has been more than offset by the impact of the pandemic. COVID-19 has hit many sectors of the commercial property market especially hard, as physical businesses have had to close, and many behavioural trends encouraged by the virus have threatened the outlook for property demand in the longer term.
  • While the pandemic may have accelerated certain structural trends which could hurt some of the sectors in which REITs invest (see here & here), we anticipate a cyclical recovery in commercial property markets over the next two years, as COVID-19 is contained and the economic recovery in the US continues. Meanwhile, we do not think that US REITs will be held back by a big rebound in Treasury yields, which we expect to be anchored close to current levels by ultra-loose monetary policy.
  • In that scenario, we think that US REITs – the valuations of which have rarely been lower in the past 20 years relative to US Treasuries and corporate bonds, and relative to ordinary US equities (see Chart 3) – could rally, with some of 2020’s underperformance relative to ordinary equities (See Chart 4) unwinding.

Chart 1: Dividend Yields (%)

Chart 2: US Treasury Yield & US REITs Vs. Equities

Chart 3: Dividend Yield Of FTSE Nareit Equity REITs Index Less Yields From Other Assets (%-pt)

Chart 4: Rebased Total Returns Indices (31st Dec. 2019 = 100)

Sources: Refinitiv, Capital Economics


Oliver Allen, Markets Economist, oliver.allen@capitaleconomics.com

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