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Friday, July 6, 2007

Should REITs Rally?

The last few trading days have seen REITs rallying. Yesterdays article in the Wall Street Journal described an environment ofrapidly rising rents in a handful of high profile cities. This trend is driven, they say, by all the new private equity owners of office buildings that have changed hands during the recent buyout boom. These new owners have onerous debt burdens and they need to raise rents in order to pay down debt.

What was unusual about yesterday's activity was that REITs went up (based on the WSJ article?) even as interest rates rose. Usually, I thought, rates and REITs are uncorrelated; ie, they usually move in opposite directions.

They chart below shows how a REIT ETF, the iShares Dow Jones US Real Estate ETF (IYR), and rates on the 10-year note have moved over the last two years. As you can see, the last time rates were this high, in the summer of 2006, IYR was trading under $70 per share. Yesterday it closed over $80


Chart of IYR, $TNX and Yield
Also displayed in this chart is the yield on IYR. Yields are often described as a prime reason to own REITs as they provide a steady stream of income when profits are returned to investors. It can be clearly seen that the yield over the past year has barely budged even as the ETF rallied strongly since early 2006. Indeed, it is actually a bit lower now than it was when the ETF was trading in the $60's back in 2006.

Where does all this leave us? Not all office markets across the US are red-hot. The interest rate environment does not look friendly to REITs based on a historical perspective. Yields have not risen sufficiently to make REITs compelling when I can get a better rate in a CD or any online bank account with much less risk. It seems doubtful to me that REITS can sustain their recent strength.

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