Morningstar Advisor - October/November 2010 - 28

Gray Matters

Exhibit 3 REITs Offer Low Compensation …
Equity REIT Dividend Yield vs. 10-Year Constant Maturity Treasury Yield

note has been hovering below the 20-year average Exhibit 4. The compensation for owning REITs was much better a year ago. REITs may offer the possibility of growth, while Treasury notes do not, but REITs also court more risk with their debt-burdened balance sheets and the possibility of deflation crimping their cash flows. An advantage of dividend analysis over FFO analysis is that we are able to see what investors’ five-year returns would be when buying at various dividend yield ranges from the beginning of 1992 through June 30, 2010 Exhibit 5. Buying REITs at an average dividend yield of 4% to 5% produced virtually no return over the next five years. Buying at a 6% to 7% average yield produced a 12% annualized return for the next five years, while buying at an 8% to 9% yield produced a whopping 16% annualized return for the next five years.
Folding in Morningstar’s Equity Analysis

January 1990–July 2010
12% 10 8 6 4 2 90 92 94 96 98 00 02 04 06 08 10
Equity REITs 10–Year Treasury

Exhibit 4 … And Below-Average Yield Spread
Monthly Equity REIT Dividend-Yield Spread

January 1990–July 2010
8% 6 4 2 0 –2 90 92 94 96 98 00 02 04 06 08 10
Average Yield Spread 1990–2010: 1.03

Morningstar’s equity analysts predict companies’ cash flows in the future, and their analysis paints a slightly happier picture than the one suggested by trailing our FFO and yield-spread analyses—but not much happier. The average Morningstar Rating of the top 15 stocks in our four real estate funds is 2.7 stars as of Aug. 18, which means that, on the whole, the stocks are trading at slightly more than Morningstar analysts’ fair value estimates. Forecasting future cash flows isn’t perfect. Borrowing conditions, for example, can change and alter a REIT’s future returns. Also, companies in the sector sometimes radically change their structures, selling and buying large blocks of property. Finally, apartments and hotels function with what are basically one-year and one-night leases, respectively, making it tougher to normalize their future cash flows than those of office and industrial properties with multiyear leases and built-in inflation adjustments.

Yield spread calculated by taking the Equity REIT dividend yield less 10-year constant maturity Treasury yield. Sources: NAREIT, FactSet.

10 9 8 7 6 5 4 3 2 1 0 -1 -2 Ja FJ M M A e A

Examining Yield Spreads

Price/FFO doesn’t look lovely, and neither does actual dividend yield. None of the three funds reporting current yields as of May 14— the offerings from Fidelity, Vanguard, and Cohen & Steers—is paying out more than 3%, which is lower than most analysts have seen in recent memory.

To put that yield in context, analysts often compare REIT dividend yields with the interest rate of U.S. Treasuries. Until the recent dip in the Treasury yield, REIT investors were getting paid less to own REITs than they were in interest payments from safer U.S. Treasury notes Exhibit 3. The REIT dividend yield relative to the yield of a 10-year U.S. Treasury

28 Morningstar Advisor October/November 2010

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Morningstar Advisor - October/November 2010

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