VNQ And REITs Pressured By Rising Rates (NYSEARCA:VNQ)

Thesis and background

We use the following market sector dashboard to put our finger on the pulse of the market and its major sectors. Especially, the simple YS (yield spread, defined as the TTM dividend yield minus the 10-year treasury rates) is the first thing we look at. They give us a 30,000 feet view of where to look further – which sector, growth stocks, value stocks, bonds, or precious metals, et al. We will detail the meaning of each entry in the next section, and we update the dashboard monthly. Feel free to download or export the google-sheet via the following link too: Market Sector Dashboard.

A few overall impressions on the market and the Vanguard Real Estate ETF (VNQ) this month:

• The yield spread between VNQ and risk-free rates is not at an attractive level currently. With a YS Z-score slightly negative (-0.06), VNQ (and the REIT sector in general) is at best fairly valued or somewhat overvalued compared to its historical spectrum.
• The rapid rise of treasury rates will keep pressure on the sector. The 10-year treasury rates just surged above 2.15% for the first time since July 2019 and is expected to rise further based on the latest Fed dot-plot.
• Furthermore, the overall market (represented by a simple average of the sectors in the dashboard) also features a slightly negative yield spread relative to the treasury rates (Z-score about -0.2%). It is almost zero. But for us, it is to be monitored closely. If it turns further and more conclusively negative, it then signals that the fundamental dynamics between bond valuation and equity valuation is starting to change. The yield spread Z-score has been positive (or almost positive) since later 2019.
• Lastly, the results and dashboard apply to other similar funds, too, such as the Real Estate Select Sector SPDR Fund (XLRE) and iShares U.S. Real Estate ETF (IYR), because these funds are quite similar and their valuation closely correlated.

With the above overall discussion, we now move on to the specifics of the dashboard and VNQ.

The dashboard explained

Note: if you are familiar with our Market Sector Dashboard already, you can skip this section. It describes the mechanics of the dashboard.

• The yield spread Z-score. It gauges the dividend yield of a given sector relative to the 10-year treasury rates. How the yield spread is calculated will be detailed in the next section. A larger Z-score suggests larger undervaluation compared to the historical record and treasury rates. And vice versa.
• A Z-score that is closer to 1 means the yield spread is near the thickest level of the historical spectrum and is color-coded by bright green. And vice versa.
• The yield spread Z-score. Similar to the yield spread Z-score, it gauges the dividend yield of a given sector relative to its own historical record. A larger Z-score (greener) suggests a larger undervaluation compared to its own historical record. And vice versa.

Yield spread and yield spread Z-score

For bond-like equities fund VNQ, an effective way to evaluate their valuation with interest rates adjusted is to calculate the yield spread. Details of the calculation and application of the yield spread have been provided in our earlier article. The yield spread is an indicator we first check before we make investment decisions. We’ve fortunately had very good success with this indicator because of:

• Its simplicity – it only relies on the most simple and reliable data points (treasury rates and dividends). In investing, we always prefer a simpler method that relies on fewer and unambiguous data points rather than a more complicated method that depends on more ambiguous data points.
• Its timeless intuition – no matter how times change, the risk-free rate serves as the gravity on all asset valuations and, consequently, the spread ALWAYS provides a measurement of the risk premium investors are paying relative to risk-free rates. A large spread provides a higher margin of safety and vice versa.

With this background, you will see below that when adjusted for interest rates, VNQ’s current valuation is not at an attractive level.

The following chart shows the yield spread between VNQ and the 10-year treasury. The dividend yield is calculated based on the TTM dividends. As can be seen, the spread is bounded and tractable most of the time. The spread has been in the range between about 0.5% and 2.75% the majority of the time during the past decade. Such a tractable YS suggests that when the spread is near or above 2.75%, VNQ is significantly undervalued relative to the 10-year Treasury bond (i.e., I would sell treasury bond and buy VNQ). In another word, sellers of VNQ are willing to sell it (essentially an equity bond with growth built-in) to me at a yield that is 2.75% above the risk-free yield. So it is a good bargain for me. And vice versa.

You can see the screaming signal in 2020 when the yield spread surged to the 3.5%+ level – and this is why this dashboard is the first thing we look at when we make our investment decisions.

As of this writing, the spread is about 0.72%, as you can see. It is a level that is close to the narrowest end of the historical spectrum and is below the historical average by a wide margin. Such a narrow yield spread signals at best fair valuation or some overvaluation relative to risk-free rates.

For readers familiar with our analyses, you know that the short-term returns are closely correlated with the yield spread for many of the funds and stocks. And as you can see from the chart below, it is also true for VNQ. This chart shows the one-year total return on VNQ (including price appreciation and dividend) when the purchase was made under different yield spread. There is a clear positive trend and the Pearson correlation coefficient of 0.35.

Again, the screaming buying opportunities in 2020 are shown by the two data points on the far-right side of the charts. And you see the outsized return in the next 1 year.

In general, also shown in the orange box, when the spread is about 2.5%, the total returns in the next one year have been all positive and quite large (as large as 30%+ in two cases).

As of this writing, the yield spread is 0.72% and the YS Z-score is -0.06, close to the narrowest end of the historical spectrum.

Conclusions and final thoughts

We use a Market Sector Dashboard to put a finger on the pulse of the market and its major sectors. For this month, our key observations are:

• With a YS Z-score slightly negative (-0.06), VNQ (and the REIT sector in general) is not attractively valued compared to its historical spectrum.
• The rapid rise of treasury rates will keep pressure on the sector. The 10-year treasury rates just surged above 2.15% for the first time since July 2019 and is expected to rise further based on the latest Fed dot-plot.
• Furthermore, the overall market also features a slightly negative yield spread relative to the treasury rates (Z-score about -0.2%). It is almost zero. But for us, it is to be monitored closely as it could signal a fundamental change between bond valuation and equity valuation.

Thanks for reading, and looking forward to your comments!