Changes in the yield environment following the Fed’s comments about “tapering” asset purchases under their current quantitative easing program on May 22 was very disturbing for REIT investors. However, now that the information is out and the news has been discounted, investors are looking at REITs as a source of profits again.
It’s All About the Income
A REIT is subject to special tax regulations that allow them to pay almost no corporate tax if they distribute 90% or more of their net income to shareholders. The shareholders are then typically responsible for those dividends as ordinary income (vs. capital gains), which is why they are popular stocks to hold within a Roth IRA. Despite these potential tax problems, REITs are popular investments for income seekers and are often the best-performing asset class in the market over the long run.
Following Ben Bernanke’s comments on May 22, REITs lost 18% on average. That is a big drop regardless of the asset class, but probably represents a bubble that needed to burst anyway. Investors who would normally be interested in bonds were pushed into income stocks like REITs because yields were too low.
Traders assumed that if the Fed reduced its asset purchases then not only would demand for REITs be decline but real estate prices in the U.S. would also take a hit without as much of the Fed’s support. Those seem like reasonable assumptions to us, but the most important question is whether the impact of tapering has now been fully priced into the market for REITs. From a technical perspective, we think that is the case and support is likely to come into play at this level. It is even possible that investors have over-discounted the Fed’s actions and REITs are too cheap considering current yields.
REITs vs. REIT ETFs
There are many individual REITs to choose from that cover just about any kind of real estate investment you can imagine. Some invest in residential or commercial real estate while others buy timber property, mortgage-backed bonds, or even storage units. There are also REIT ETFs that diversify their holdings across multiple REITs and real estate groups. For example, the Vanguard REIT ETF (VNQ) holds investments in health care, public storage, and residential/commercial property REITs all within its top 10 holdings.
Click to Enlarge VNQ is our recommendation because of its low costs and liquidity. The stock is also compelling from a technical perspective. As you can see in the weekly chart, VNQ dropped with the rest of the industry but stopped this week at the top of its long-term support range of $63-$65 per share. This support level was resistance in 2008 during the Lehman brothers collapse. It was also resistance following the debt ceiling crisis of 2011, but became support following the market’s rally through 2012.
REITs are generally considered a longer-term investment because of the impact of the high dividends on the total return. For example, despite the market decline in 2008, REITs have been the top performing asset class in the market when you include dividends. Currently, dividend yields are back up because prices have fallen, which is likely to have a very positive impact on the stock as yield-seekers move back in.
This decline had some great timing. It has been more than a year since the last rally, which means there were some profit-takers exiting with long-term capital gains. That drove prices low enough to attract new buyers (so far anyway), who are likely to be “locked in” the trade for another year at least. Assuming the market doesn’t crash, these long-term investors will push prices higher as they try to get in at relatively cheap prices.
Recommendation: For short-term traders who want to take advantage of the bullish impact of long-term accumulation, we expect prices to hit $75 per share over the next quarter. The market is calling the Fed’s bluff. This wouldn’t be the first (or second, or third) time the Fed has had to abandon plans to pull back on purchases over the last few years as asset prices responded negatively. We like an entry in the stock at $65-$67 per share but would suggest setting stops below $60 to protect against an unexpected decline.
Options Alternative: Call options on VNQ could also be an interesting opportunity but traders should be very careful about their entry. Call option prices on big dividend payers can be a little tricky to analyze. Because the stock drops as cash-dividends are paid, call option premiums should be discounted, however, call prices are a little inflated currently on VNQ. There are two reasons for this. First, VNQ went through its ex-dividend date on June 24, so part of the discount has been absorbed. The second reason is that we aren’t the only analysts who expect prices to rise. Option sellers are pricing in the potential for a big rally into the price of those calls. Out of the money calls on VNQ have been very popular recently, which we take as a very positive sign.
For option traders, we recommend the September $66 calls for $3.00 per share or less (The current ask price is $3.60, so be patient). We recommend setting a conditional stop on those options if the stock drops below $60 per share. We expect prices to hit $75 in the short term, when short-term option investors may exit to take profits if the stock begins consolidating.
InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.