Economic volatility has struck globally: China’s equity markets are in meltdown and the Greek debt crisis seems to be imploding.
But some notable analysts are still maintaining a positive outlook on real estate investment trust funds, or REITs. The core fundamental argument is that REITs are, in the words of Zacks Equity Research, “tied to the basic necessities of life such as food, housing and health care without which we cannot live for long.”
The other incentive for REITs is passive income, where federal law mandates that real estate investment trusts allocate 90% of yearly taxable income via dividends. Indeed, there a few individual REITs, such as American Capital Agency Corp. (AGNC) and Two Harbors Investment Corp. (TWO), that offer double-digit yields, unheard of in most investment markets.
We also can’t ignore the tremendous bull run that many REITs have enjoyed over the past several years. For example, the real estate benchmark Dow Jones Equity All REIT Index gained 25% in 2014, doubling the returns of the blue chip S&P 500 index. In addition, both TWO stock and AGNC stock enjoyed a winning streak last year, with the latter jumping up nearly 14% in value.
REITs Continue Losing Steam
But with all good things in the markets comes the inevitable reversal of fortune. The Dow Jones REIT index is down 4% year-to-date, while AGNC stock is veritably tanking to the tune of -13.3% against the same time frame. TWO stock, on the flip side, is up on a YTD-basis, but only marginally so at 1.6%.
The harsh reality is that the U.S. Federal Reserve will — at some point — make good on the hawkish monetary policy they have promised repeatedly to implement. The current Greek tragedy and the trouble in China only serve to delay the inevitable. And despite the lollygagging in Washington, the markets have already voted, with the 10-year U.S. Treasury Yield up nearly 14% YTD.
Naturally, higher interest rates would equate to increased loan costs, thus stymieing REITs and other real estate investment opportunities.
Also, the double-digit yields of AGNC stock or TWO stock can potentially be a liability in a high-interest rate environment. That’s because the bond markets would then offer enticing competition with a much higher margin of safety than common stock ownership. Additionally, equity shares with very high yields can often be a red-flag of poor performance in the markets.
This would be an apt warning for both American Capital and Two Harbors. AGNC stock has been particularly volatile since the spring season of 2013, rising above $24 in April of that year and crashing below $16 a few months later in November. TWO stock has fared significantly better from a market value perspective; however, it too recently met a sharp series of selloffs in late April of this year.
As would be expected due to their similarities, both stocks share a strong lifetime correlation of 0.85. In the current market context, however, this correlation may be worrying for investors — whatever is notably ailing AGNC stock would seem to have a high probability of negatively impacting TWO stock as well.
Further cementing this point, despite TWO stock’s trajectory veering away from AGNC stock’s bearish trend starting from January of 2013, the statistical correlation from then until now is still at a very strong 0.7.
It’s hard to turn your back on double-digit yields, but then again, there’s that old adage about something being too good to be true. For AGNC, TWO, and similar REITs, the inevitable challenges soon to face real estate investment markets may be too much to overcome.
As of this writing, Josh Enomoto did not hold a position in any of the aforementioned securities.
