## How Would Mr. Bogle Calculate Expected REIT Returns?

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Bill Bernstein
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### How Would Mr. Bogle Calculate Expected REIT Returns?

Hi all:

I very rarely post a new topic, but I do feel compelled to comment on REITs.

I’ve seen more than a few posters remark favorably on the high realized returns of REITS, along with the “fat” dividend yield, the implication being that this can be expected to continue.

If I’ve learned anything from Jack Bogle, it’s the fundamental equation of expected return (ER):

ER = dividend yield + dividend/earnings growth + speculative return.

The yield is easy . . . around 3%.

Dividend/earnings growth is a tad harder, but easy enough to derive from the NAREIT database; over the past 41 years, dividends have grown at 2.6% pa; unfortunately, inflation in the same period ran 4.2%, for negative real dividend growth of 1.6%.

Now, all we’re left to calculate is the speculative return. Mr. Bogle, I think, would say that the historical yield should be 6%, so the doubling of the yield over the next 10 years should detract 7% pa from the return.

If that depresses you too much, I’ll be Pollyanna and posit that the yield will not change.

So, we have two estimates:

“Bogle real ER” = 3% - 1.6% - 7% = -5.6%

“Bernstein/Pollyanna real ER” = 3% - 1.6% = +1.4%

If you don’t like the above calculations, then consider this plot of starting dividend yield versus forward 5-year return:

We’re all long-term investors on this board, and I’m certainly not recommending that we all run out and sell all our REITs. But I think that anyone not experienced with the asset class who’s thinking of going out and establishing a new position in it at this time should pay less attention to its recent returns and consider the above data.

Best,

Bill

Leesbro63
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

Dr Bernstein, your stuff is great, but takes me a while to figure out what you are saying, can you summarize your point about why REITS may be "mispriced"?

Grt2bOutdoors
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

Great post Bill, thanks for putting it up there.
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Jebediah
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

Thank you for this analysis. Is this US only or global?

richard
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

Leesbro63 wrote:Dr Bernstein, your stuff is great, but takes me a while to figure out what you are saying, can you summarize your point about why REITS may be "mispriced"?

He's not saying they are mispriced. He's saying given history, if you start with a yield of 3% your return won't be very good. Look at the chart.

One may wonder if there is enough history to have statistically significant results and whether current conditions are sufficiently similar to past conditions that history is a reliable guide, but if you accept the premises, REITs don't look like a great investment at the moment.

EmergDoc
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

Does anything look like a great investment right now? It feels a lot like 2007 when everything seemed richly valued. Maybe a good time to pay down debt!
1) Invest you must 2) Time is your friend 3) Impulse is your enemy | 4) Basic arithmetic works 5) Stick to simplicity 6) Stay the course

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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

First, wbern is William Bernstein.

Abbreviation: "pa" is "per annum" (yearly)

Here is the NAREIT database: Index Data (About NAREIT)

I found the historical data (1972 - 213) and downloaded the spreadsheet: Monthly Historical Index Data: 1972-2013 (The annual data does not have dividend yield.) There are 6 US REIT Index Series. Which index was used and how was the 2.6% pa dividends derived? I could not reproduce the results.

I don't know what I did wrong - The average of the dividend yield over the full range is 7.9% = average(g10:g506)). Alternatively, taking the difference is 3.92% = g506 - g10. (December 1971 to April 2013)
To some, the glass is half full. To others, the glass is half empty. To an engineer, it's twice the size it needs to be.

zaboomafoozarg
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

Interesting... ah well, I've got 30 years until retirement, I think I'll keep 'em.

InvestorNewb
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

REITs make up about 20% of my portfolio... and I only bought in about 3 months ago. Hopefully today's "high" will be next year's low.

It just seems that for everyone who says not to buy REITs in 2013, somebody else comes along and says they're a great investment. I find it difficult to discern between all the contradictory advice.

For me they are a long-term investment, so I'd rather just buy in now so the money is in the market longer.
My Portfolio: VTI [US], VXUS [Int'l], VNQ [REIT], VCE [Canada] (largest to smallest)

woof755
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

zaboomafoozarg wrote:Interesting... ah well, I've got 30 years until retirement, I think I'll keep 'em.

A good percentage of folks on this board hold REITs for diversification, not yield / return chasing. People like you, and them, are not really who Dr. Bernstein is talking about, methinks.
"By singing in harmony from the same page of the same investing hymnal, the Diehards drown out market noise." | | --Jason Zweig, quoted in The Bogleheads' Guide to Investing

Bill Bernstein
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

I'm using the equity REIT series. Using a starting value for the index of 100 and a yield of 6.13%, that's \$6.13 of dividends per share.

In April '13, those numbers were 578 and 3.28%, for a dollar per share dividend of \$18.98 per share. So (18.98/6.13)^(1/41.333)-1 is 2.77% pa (The data from my OP was stale to the tune of -0.17%, I see). (We're looking at columns AG and AI in the NAREIT SS).

I'm only talking about the U.S.

When I average column AI I come up with 7.07%.

As I like to say, a belief in efficient markets doesn't absolve you from calculating expected returns.

Bill
Last edited by Bill Bernstein on Mon May 06, 2013 10:11 pm, edited 1 time in total.

stratton
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

Green Street Advisors has a chart they keep of REIT NAV premiums.

Hit the "historical data" tab at the bottom of the page to see the chart. Currently we are at a 19.1% NAV premium. Long term average is 3.1%

Paul
...and then Buffy staked Edward. The end.

Random Musings
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

Bill, I would like to thank you for your observations. I guess some may believe that it will be "different this time"' but the odds are most likely not in their favor.

Larry S. has commented recently that intl REIT's are a better value than domestic, but even there, that does not guarantee they will perform better than domestic ones.

IMHO, there are not really any major asset classes that scream "buy" right now. More like hold on.

RM
I figure the odds be fifty-fifty I just might have something to say. FZ

ruralavalon
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

wbern wrote:We’re all long-term investors on this board, and I’m certainly not recommending that we all run out and sell all our REITs. But I think that anyone not experienced with the asset class who’s thinking of going out and establishing a new position in it at this time should pay less attention to its recent returns and consider the above data.

I didn't understand any part of the calculation, but the last two sentences are clear to me.

Just a four days ago I rebalanced my REIT holding down to target.

Thanks for the input.
"Everything should be as simple as it is, but not simpler." - Albert Einstein | Wiki article link:Getting Started

Grt2bOutdoors
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

If REITS are over-valued, what does that say for other areas of the real estate market?
We have one opinion from Rick Ferri indicating "homes are an investment once again" and math says REITS as a whole including residential reits are in nose-bleed territory.
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Grt2bOutdoors
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

Random Musings wrote:Bill, I would like to thank you for your observations. I guess some may believe that it will be "different this time"' but the odds are most likely not in their favor.

Larry S. has commented recently that intl REIT's are a better value than domestic, but even there, that does not guarantee they will perform better than domestic ones.

IMHO, there are not really any major asset classes that scream "buy" right now. More like hold on.

RM

I hold a global REIT in my 401k (only Reit option available) - 43% of the fund in invested in US Reits - the majority held in Retail Reit.
"Luck is not a strategy" Asking Portfolio Questions

Valuethinker
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

Grt2bOutdoors wrote:If REITS are over-valued, what does that say for other areas of the real estate market?
We have one opinion from Rick Ferri indicating "homes are an investment once again" and math says REITS as a whole including residential reits are in nose-bleed territory.

REITs are not commercial Real Estate-- that's the underlying asset but there are a lot of other layers.

You need to look at cap rates. There, I think, buildings are going for 5-6%? That's not bad, but it's not a steal. FWIW I think US commercial RE will do well over the next few years as the economy recovers. HOWEVER I may not be right on cap rates, and the VG fund is just not offering an attractive yield to my mind.

So I would summarize as: TIAA RE annuity OK, VG REIT index fund not OK. In the long run, the two should track each other.

Note Residential REITs own apartments. What's happening in the housing market (I posted about it, Calculated Risk called the turn in March 2012) is that the US housing market has bottomed and is 'spiking' up due to supply shortage. This is single family residential homes (and to a lesser extent condos where there has been no new supply for 5 years due to financial restraint on bank lending). That's a different market, largely, from apartment houses.

Offices I think are probably fair value, but blue chip offices probably overpriced (along with all blue chip yield assets). Industrial promising given what's happening to US industrial sector. Apartments probably promising but value may have moved. Retail I think has to have lots of questions given sluggishness of consumer income growth, internet shopping etc. and overspacing. Hotels and health care I just don't know (hotels very cyclically sensitive so should be better). Leisure I am not sure. My main concern would be retail. that's all impressionistic without having done any homework. You have to look at cap rates and where each subsector is in, in the cycle.

Calculated Risk is far and away your best source for macro data. Maybe Green Street for the sector analysis.
Last edited by Valuethinker on Tue May 07, 2013 8:59 am, edited 1 time in total.

Valuethinker
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

InvestorNewb wrote:REITs make up about 20% of my portfolio... and I only bought in about 3 months ago. Hopefully today's "high" will be next year's low.

It just seems that for everyone who says not to buy REITs in 2013, somebody else comes along and says they're a great investment. I find it difficult to discern between all the contradictory advice.

For me they are a long-term investment, so I'd rather just buy in now so the money is in the market longer.

Usually when we disagree it doesn't really matter .

If you are holding 10% or less then it's a neither nor. In the long run it should be a good investment. The danger is when we are in the middle of one of those commercial Real Estate slumps (and they last for years and years: New England 1990-1998 about, Toronto had a building started in 1989 that was not finished until around 2004) that you cut and then run.

What happens is you get performance chasing. A sector does well and we get a raft of posts about Harry Brown and 25% in gold. OK you are Craigr, you have been 25% in gold since the 1990s, you have done well. But we don't get so many posts about gold right now . Most of the posts come from relatively new investors.

We've had fads for REITs, too. And High Yield bonds. And 100% stocks. And international. And 0% international. And overweighting Emerging Markets. And 100% small value. Often these come with threads about 'the US is going to pot/ hyperinflation/ depression/ etc.' or 'international is going to pot/ eurocrisis/ fascism' etc. You get the feeling these posters only discover their newspapers about 2 months late. Usually come after some pundit like Cramer or Shiff has opined on cable tv shows.

Just so you know, Canadian pundit named Brian Costello, I sat on Air Canada listening to his talk show about Emerging Markets funds in 1993-- NAFTA etc. it was all glorious. Mexico needed a US Treasury bailout the next year, and Emerging Markets were a (volatile) dog for the rest of the 1990s. Rest assured we've been there and some of us got sucked in (me in the dot com crash, with my own employer).

I''ve probably missed a few. There will be others.

Hub
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

Interesting information. I haven't bought any more REIT funds in 18 months or so and they're still a few percentage points higher than I would like in my asset allocation. Sounds like it is a good time to be not buying more of them while my future contributions continue to rebalance my REIT % down.

Garco
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

Valuethinker wrote:
Grt2bOutdoors wrote:If REITS are over-valued, what does that say for other areas of the real estate market?
We have one opinion from Rick Ferri indicating "homes are an investment once again" and math says REITS as a whole including residential reits are in nose-bleed territory.

REITs are not commercial Real Estate-- that's the underlying asset but there are a lot of other layers.

You need to look at cap rates. There, I think, buildings are going for 5-6%? That's not bad, but it's not a steal. FWIW I think US commercial RE will do well over the next few years as the economy recovers. HOWEVER I may not be right on cap rates, and the VG fund is just not offering an attractive yield to my mind.

So I would summarize as: TIAA RE annuity OK, VG REIT index fund not OK. In the long run, the two should track each other.

TIAA Real Estate annuity (TREA) mainly directly owns commercial real estate (mainly in U.S. but some in Europe). But it invests some of its cash (5-10%) in commercial REITS, and this accounts for some of the day-to-day variation in the NAV as well as contributes to (or detracts from) the growth in valuation.

KarlJ
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

Is the implication of the chart in the OP to wait until the REIT dividend yield reaches 8% before buying a REIT index fund?

Valuethinker
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

KarlJ wrote:Is the implication of the chart in the OP to wait until the REIT dividend yield reaches 8% before buying a REIT index fund?

At least never to buy it below a 4% yield.

The thing with REITs is the dividend payout is fixed by tax law (90% of Funds Flow from Operations I believe). So there's no PE valuation underlying there, where companies can increase their dividends (ie the typical company only pays out half its earnings in dividends or stock buybacks say-- I don't know the actual number but I suspect it's around 40%). (technically companies earn Earnings Per Share, and pay Dividends Per Share out of that-- the ratio of EPS/ DPS is cover, and a payout ratio of 50% means 2:1 cover -- the cover for a REIT would be more like 1.1: 1).

So other than rental growth, the dividend you get from a REIT is your return, long run, pretty much.

Artsdoctor
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

I think we are extraordinarily fortunate to have Bill Bernstein weigh in on this topic . . .

Thank you very much, Bill.

Kulak
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

EmergDoc wrote:Does anything look like a great investment right now? It feels a lot like 2007 when everything seemed richly valued. Maybe a good time to pay down debt!

Or just spend it. Being in debt is cheap now too, and higher rates and/or inflation are probably coming. Plus there are the non-financial risks (political, premature death).

OTOH, I think many Bogleheads get more "utility" out of saving itself -- intrinsically, without the promise of future consumption -- in defiance of Econ 101 teachers everywhere.
Depriving ourselves to boost our 40-year success probability much beyond 80% is a fool’s errand, since all you are doing is increasing the probability of failure for [non-financial] reasons. --wbern

larryswedroe
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

The important point for investors to keep in mind that Bill is raising is that VALUATIONS matter and they matter a great deal

AT some point one must decide if the risks are worth taking--like when the S&P had p/es in the 40s and NASDAQ at 100--that literally doomed investors to lousy returns at best and huge losses at worst.

The problem with this is there are no "red lines" in the sand that say "now is the time to get out". In other words, is a p/e of 20 too high, or 25, or 30, and then when do you get back in.

As I showed with the Shiller P/E 10 valuations clearly matter as the potential dispersion of returns moves monotonically lower as valuations rise, but there is still a wide dispersion even at high P/Es.

Personally I sold all but small value in 98 and moved to the Larry Portfolio, a bit too early as it turns out, missing two more great years, but certainly was right over the long term. I also sold domestic REIT holdings a while ago for the same reasons Bill explained.

Timing is a very slippery slope and IMO best avoided by almost all investors--and the way to minimize the risks of these type high valuations is to DIVERSIFY across as many asset classes and risk factors as possible/efficient and rebalance--so you benefit from the "bubbles" and sell high and buy when they burst.

Larry

larryswedroe
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

The important point for investors to keep in mind that Bill is raising is that VALUATIONS matter and they matter a great deal

AT some point one must decide if the risks are worth taking--like when the S&P had p/es in the 40s and NASDAQ at 100--that literally doomed investors to lousy returns at best and huge losses at worst.

The problem with this is there are no "red lines" in the sand that say "now is the time to get out". In other words, is a p/e of 20 too high, or 25, or 30, and then when do you get back in.

As I showed with the Shiller P/E 10 valuations clearly matter as the potential dispersion of returns moves monotonically lower as valuations rise, but there is still a wide dispersion even at high P/Es.

Personally I sold all but small value in 98 and moved to the Larry Portfolio, a bit too early as it turns out, missing two more great years, but certainly was right over the long term. I also sold domestic REIT holdings a while ago for the same reasons Bill explained.

Timing is a very slippery slope and IMO best avoided by almost all investors--and the way to minimize the risks of these type high valuations is to DIVERSIFY across as many asset classes and risk factors as possible/efficient and rebalance--so you benefit from the "bubbles" and sell high and buy when they burst.

Larry

InvestorNewb
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

Isn't it also worth nothing that REITs still haven't reached their former high in 2007? i.e. REITs were priced higher 6 years ago. Today's "highs" are relative to the period in which we look at them. Over the last 3-4 years, it does feel like a bubble. But over the last 10, it doesn't. I'm new to investing so take this with grain of salt, but this is my perspective.
My Portfolio: VTI [US], VXUS [Int'l], VNQ [REIT], VCE [Canada] (largest to smallest)

Artsdoctor
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

InvestorNewb,

Don't look back to make decisions. The NASDAQ was over 5000 at its high in 2000 and the Nikkei was . . .

Don't wait for things to come back just because the numbers were higher in the past.

I know it's easy to just stick with a plan and buy into it. That is better than no plan. But if this forum's mentor is Jack Bogle, remember that he attempts to look forward with earnings estimates. He'll admit that they are estimates. But he still makes an attempt. You need those estimates to make an informed decision on how much to save, realizing that there is no perfect formula.

It's because of these very estimates that no one in their right mind is going to expect the same return as in the past.

Valuations do matter. Do your calculations, know where the shortcomings of those calculations are, and make your best estimate going forward.

Artsdoctor

jjustice
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

Where does Mr. Bernstein find the 3% dividend yield? Vanguard gives a "current unadjusted effective yield" of 3.54% and a "current adjusted effective yield" of 2.42%. Is either of these the number that Mr. Bernstein refers to?
John

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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

I found the historical data (1972 - 213) and downloaded the spreadsheet: Monthly Historical Index Data: 1972-2013 (The annual data does not have dividend yield.) There are 6 US REIT Index Series. Which index was used and how was the 2.6% pa dividends derived? I could not reproduce the results...(December 1971 to April 2013)
wbern wrote:I'm using the equity REIT series. Using a starting value for the index of 100 and a yield of 6.13%, that's \$6.13 of dividends per share.

In April '13, those numbers were 578 and 3.28%, for a dollar per share dividend of \$18.98 per share. So (18.98/6.13)^(1/41.333)-1 is 2.77% pa (The data from my OP was stale to the tune of -0.17%, I see). (We're looking at columns AG and AI in the NAREIT SS).

I'm only talking about the U.S. When I average column AI I come up with 7.07%. As I like to say, a belief in efficient markets doesn't absolve you from calculating expected returns. Bill

Thanks, I matched your correction. To share what I learned:

The growth rate is the interest rate found from the Time Value of Money equation: FV = PV (1 + i)^N

Solve for: i = (FV / PV )^(1/N) - 1 <== the exponent means this is a geometric average return, which accounts for the effect of compounded interest. Without compounding, it would be a simple average return.

Dollars/ share = dividend yield% * index /100
PV = \$6.13 = 100 * 6.13% / 100
FV = \$18.98 = 578.80 * 3.28% /100
N = 41.33 = YEARFRAC(12/31/1971, 4/30/2013, 1) <== LibreOffice, actual Day count convention

i = 2.77% = (18.98/6.13)^(1/41.33) - 1

For those who want to understand "the basics" on the above, it's in the wiki: Comparing Investments

(For this example, I had some help from "Finance: Financial Markets, Business Finance, and Asset Management" by Frank J. Fabozzi and Pamela Peterson Drake, 2009)
To some, the glass is half full. To others, the glass is half empty. To an engineer, it's twice the size it needs to be.

czeckers
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

It is a truly rare and noteworthy event when someone of Dr. Bernstein's status in the financial industry takes the time to go out of his way to post here to specifically warn us about the future outlook of a particular investment. I certainly take note. Thank you Dr. Bernstein for sharing your insights with us.

The last time I noticed something like this on this forum was when Mr. Bogle himself posted prior to the crash of 2008 cautioning us all to "be careful".

When I looked into the VG international REIT fund last year and saw that the yield was significantly higher than the US REIT fund, I went for greater diversification by splitting my REIT allocation equally between the two funds.

-K
The Espresso portfolio: | | 16% LCV, 16% SCV, 16% EM, 8% Int'l Value, 8% Int'l Sm, 8% US REIT, 8% Int'l REIT, 20% Inter-term US Treas | | "A journey of a thousand miles begins with a single step."

gasman
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

Kulak wrote:
EmergDoc wrote:Does anything look like a great investment right now? It feels a lot like 2007 when everything seemed richly valued. Maybe a good time to pay down debt!

Or just spend it. Being in debt is cheap now too, and higher rates and/or inflation are probably coming. Plus there are the non-financial risks (political, premature death).

OTOH, I think many Bogleheads get more "utility" out of saving itself -- intrinsically, without the promise of future consumption -- in defiance of Econ 101 teachers everywhere.

swaption
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

Dr. Bernstein,

Thank you for your post. It is indeed thought provoking. But I am going to question a few things, understanding that this may be akin to walking into a bar and picking a fight with the 300 pound weight lifter.

I understand that your analysis is not necessarily dependent on the speculative return component in what might be Mr. Bogle's approach. But I'm not sure if using the speculative return component is valid in the first place. How is it any different than assigning a speculative return component to a bond fund assuming yields return to historical averages? To some extent we explain that type of approach with bonds. I guess REITs and stocks generally are more complex, so more difficult to explain away. But at the end of the day, it's hard to see an assertion of REIT yields returning to historic averages in 10 years as anything other than a bet that interest rates over that time from will move in a manner well outside the bounds of what is currently being priced into the market.

I'm not going to question your assertion regarding historic dividend growth of 2.6% and inflation of 4.2%. What I'm not sure about is how that is valid as a proxy for the future. I work a lot with models, but as well for the sake of employment continuity those models have to make some semblance of sense fundamentally. While of course it is possible for these two levels to diverge historically, I can't think of any fundamental reason why dividends should grow at a rate any lower than inflation in the future. What does this say about what the dividend level looks like if this continues indefinitely? It's not a pretty picture, but then again not sure if it necessarily makes sense.

Actually (subsequent edit), one might argue that over the long term, dividend growth should be mean reverting to inflation. So perhaps over the next 41 years we can actually look forward to REIT dividend growth at 1.6% above inflation. Who's the Pollyanna now?

Bill Bernstein
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

No.

There's a good reason why the per-share earnings and dividends of the U.S. companies making up the broad market grow about 1.4% faster than inflation, and that's because they reinvest a substantial portion of those earnings.

And there's a good reason why REITs' per-share earnings don't grow faster than inflation, and that's because they have to distribute out 90% of earnings as dividends.

REITs have only two ways to raise substantial capital:

1) They can, and frequently do, issue debt. This doesn't decrease per-share dividend growth, but it sure makes them more leveraged, and thus riskier.
2) They can, and frequently do, issue shares. This most certainly does decrease per-share earnings growth through dilution.

Bill

garlandwhizzer
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

One reason I have reservations about SCV index funds in general is the high percentage of REITS, which I consider overvalued, in their portfolios. REITS have done very well indeed for more than a decade and this has provided a nice tailwind for SCV returns. They have done so well for so long that I strongly believe (as do many who look at their fundamentals) that they are quite overvalued at present. I don't know when it will happen, but I believe that at some point their allure will diminish and they will become long term under-performers relative to TSM which has better valuations by multiple standards, higher earnings growth rates, and clearly offers more sector diversification.

I know many Bogleheads love them as a non-correlated asset, but I much prefer TSM at this point in time and am now a conscientious objector to US REITS.

Garland Whizzer

bottomfisher
Posts: 398
Joined: Fri Jan 04, 2013 9:03 am

### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

A few respected, very knowledgable forum members have opined that REITs appear overvalued currently. Any thoughts on foreign REIT's and expected returns?

cheapskate
Posts: 620
Joined: Thu Apr 26, 2007 1:05 pm

### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

bottomfisher wrote:A few respected, very knowledgable forum members have opined that REITs appear overvalued currently. Any thoughts on foreign REIT's and expected returns?

Larry posted on Dec 15 2012 that Intl REITs were downright cheap comparitively in this thread. I have been building up a position in Intl REITs since then (tilting my REIT allocation heavily towards Intl).

viewtopic.php?f=10&t=107055

Huge thanks to wbern and larry for warning readers about the potentially dangerous high valuation of domestic REITs !!

Sammy_M
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

czeckers wrote:It is a truly rare and noteworthy event when someone of Dr. Bernstein's status in the financial industry takes the time to go out of his way to post here to specifically warn us about the future outlook of a particular investment. I certainly take note. Thank you Dr. Bernstein for sharing your insights with us.

The last time I remember W. Bernstein sounding a similar alarm was in his 2008 Darkside of the Moon article.
William J. Bernstein wrote:The debt markets are so out of whack that we are now at a point where credit risk is being rewarded more than equity risk, something that should never happen in a world where equity investors own only the residual rights to earnings. This cannot last for very long: either spreads will tighten rapidly, equity prices will fall rapidly, or both. (Or, chortle, earnings will grow more rapidly.) Stay tuned.

Bill knew something was amiss. It caught my attention, but I unfortunately made the bozo move of increasing exposure to the credit risk "reward". In hindsight, the debt markets were right and the equity markets were wrong. Equity valuations were simply too high and the equity risk premiums far too low. A much smarter move would have been to decrease equity exposure.

Yep, valuations matter.

swaption
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

wbern wrote:No.

There's a good reason why the per-share earnings and dividends of the U.S. companies making up the broad market grow about 1.4% faster than inflation, and that's because they reinvest a substantial portion of those earnings.

And there's a good reason why REITs' per-share earnings don't grow faster than inflation, and that's because they have to distribute out 90% of earnings as dividends.

REITs have only two ways to raise substantial capital:

1) They can, and frequently do, issue debt. This doesn't decrease per-share dividend growth, but it sure makes them more leveraged, and thus riskier.
2) They can, and frequently do, issue shares. This most certainly does decrease per-share earnings growth through dilution.

Bill

To simplify this, I imagine a single building REIT that does not expand. For the moment forget about depreciation. Once again for simplicity, assume whatever maintenance expenses are sufficient to maintain the buildings value. I know the rule is to distribute 90% of earnings but let's make it easier by assuming 100%. What you end up with is indeed very simple. You have assets that maintain a static book value and constant level of dividends.

But presumably all revenue and expenses should be expected to increase with inflation, and as a result so should earnings, cash flow and dividends. Seems to make sense, but also strange to have increasing earnings with a static book value of the asset. But that book value is a fiction. They don't call is a real asset for nothing. The economic value of the asset should increase with inflation, regardless of the book value.

In summary, in the simplified example, one should not need any retained earnings to grow pretty much everything with inflation. Not now, but in a further post I will layer in depreciation, capital improvements, etc.
Last edited by swaption on Sun May 12, 2013 7:05 am, edited 1 time in total.

Jack
Posts: 3254
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

Sammy_M wrote:The last time I remember W. Bernstein sounding a similar alarm was in his 2008 Darkside of the Moon article.

And in that same article in 2008 he said "it seems highly unlikely that inflation over the next two years, any way you calculate it, is going to be less than the 1.99% yield of the two-year note."

He said this just a few months before inflation went negative and core inflation has been below that level for more than four years. Predictions, especially about the future, are hard.

lazyday
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Joined: Wed Mar 14, 2007 10:27 pm

### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

Yes, predictions are hard. He said so at the start of the article.

We had by the end of the year begun what some have called a one in appx 30 year event. Not using a Normal curve, using real world numbers.

So, "highly unlikely" could be taken as correct if one likes.

More importantly, the inflation rate was not the main point of the article. It was a supporting point.

The article as a whole turned out to be quite precient. If you read it, followed its main points, and boldly acted on it (not suggested by it) you could have profited or saved money.

Or, much more appropriately, if you had read the article, carefully considered, read more sources, and decided that equities had poor expected returns, then if acceptable to your IPS, you carefully, slightly reduced your equity exposure, you would have been better off. (In 2009 when expected returns became more acceptable you should have reversed this move.)

There are some people who did this. Unfortunately, in this event, I was not one of them, even though I read this article. My criticality of my gurus is a double edged sword.

swaption
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

Part II

Need to layer in some consideration of factors that make this a bit more complicated than above, in this case depreciation. For the most part, things like depreciation generally don't matter because it is purely an accounting concept and accounting NEVER matters. Cash flow is what it is and all accounting is supposed to be a measurement tool to give claim holders an understanding of the business. But to some extent accounting can matter if we make it matter, which we can do by using it as a basis for decision making through such metrics as P/B or P/E, etc. Depreciation is a non-cash expense so it has absolutely no impact on cash flow, so it should not matter in the above consideration for a REIT. It is why book value for a REIT is essentially meaningless, unless of course you think a building can lose 100% of it's value over the assumed depreciable life of the asset.

But in this case accounting depreciation might matter because of the unique REIT rules that require distribution of dividends based on accounting earnings. Depreciation is a non-cash expense that reduces earnings and thereby reduces the amount of required dividend distributions as compared to cash flow. But this also means it is cash flow that can be retained above and beyond earnings. This is cash flow that can be reinvested in the business without the need to issue further dilutive shares. But the logical question here is whether such cash flow is necessary to merely maintain the economic (i.e. real) value of the building, is it less, or is it more? I think the conventional wisdom is that these assets are depreciated at a far faster pace than the economic reality, so likely a safe assumption that the cash flow is at least sufficient to maintain value, and likely sufficient to increase value. So Dr. Bernstein's description of the construct does need to be modified. A REIT can retain 10% of earnings and 100% of depreciation. It is a meaningful difference.

But briefly about what can be done with that retained depreciation. Presumably a building will need some capital improvements over time. To the extent possible, and assuming there is some latitude here, I would expect REIT owners to try and expense as much of those capital expenditures as possible and avoid capitalizing in the value of the asset. Once again this is just an accounting consideration, but as we have seen expensing allows the owner of the REIT to retain more for further reinvestment, thereby reducing the need to raise more capital.

In summary, I stand by my assertion that there is no fundamental basis to expect REIT dividend growth at a level below inflation. A REIT should very much be able to grow dividend distributions at a rate at least equal to inflation. The dividend distribution requirements should not alter this analysis. First of all, it is a real asset. Value, revenue, expenses, and cash flow should track inflation. Further, accounting depreciation should be available to reinvest in the business without the need to raise additional capital.

Carpe
Posts: 211
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

swaption wrote:Part II
In summary, I stand by my assertion that there is no fundamental basis to expect REIT dividend growth at a level below inflation. A REIT should very much be able to grow dividend distributions at a rate at least equal to inflation. The dividend distribution requirements should not alter this analysis. First of all, it is a real asset. Value, revenue, expenses, and cash flow should track inflation. Further, accounting depreciation should be available to reinvest in the business without the need to raise additional capital.

Given that the data presented by Dr. Bernstein indicates that dividends are not keeping up with inflation, it begs the question, what is happening to impose such a drag on dividends? Is there any REIT (management) self-interest at play along with clever accounting that benefits the REIT management and not REIT shareholders?
Carpe: pick, pluck, pluck off, gather

swaption
Posts: 1085
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

Carpe wrote:
swaption wrote:Part II
In summary, I stand by my assertion that there is no fundamental basis to expect REIT dividend growth at a level below inflation. A REIT should very much be able to grow dividend distributions at a rate at least equal to inflation. The dividend distribution requirements should not alter this analysis. First of all, it is a real asset. Value, revenue, expenses, and cash flow should track inflation. Further, accounting depreciation should be available to reinvest in the business without the need to raise additional capital.

Given that the data presented by Dr. Bernstein indicates that dividends are not keeping up with inflation, it begs the question, what is happening to impose such a drag on dividends? Is there any REIT (management) self-interest at play along with clever accounting that benefits the REIT management and not REIT shareholders?

Yes, begs the question, but does not necessarily imply the things you mention. Could simply be cyclical factors. In other words, 41 years may not be enough time. Dividends are comprised of the following (in this order): revenue, expenses, shares/dilution, payout ratio. The answer is in there somewhere.

Some examples. Rents may have lagged inflation over the time frame. Expenses may be such that margins have compressed essentially rendering the business as less profitable. Shares may have been doled out to management increasing dilution, although theoretically this should be expensed falling into the category of impaired profitability. The payout ratio could be lower. As described above, depreciation could allow for substantial reinvestment, so perhaps the depreciation component has increased over time, thereby increasing this phantom reinvestment. Or in some combination of the above, management could be just doing a really bad job of employing new capital, essentially bleeding the business.

But like I said earlier, much of this could be mean reverting, and does not necessarily imply that this will systematically be the case going forward. More detailed analysis would be necessary to come to such a conclusion.

camontgo
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

swaption wrote:I think the conventional wisdom is that these assets are depreciated at a far faster pace than the economic reality, so likely a safe assumption that the cash flow is at least sufficient to maintain value, and likely sufficient to increase value. So Dr. Bernstein's description of the construct does need to be modified. A REIT can retain 10% of earnings and 100% of depreciation. It is a meaningful difference.

The requirement to pay out 90% of earnings is a minimum requirement. REITs can and often do pay out more than 100% of earnings. I don't know what the typical payout ratio has been historically (usually I've seen the payout ratio reported as a percent of FFO rather than earnings). Do you have historical data on the true payout ratios? Without seeing more data, I don't necessarily think it is a safe assumption that REITs will retain enough cash to offset depreciation and maintain value. It would be interesting to see how today's payouts for the index compare to the historical level.
"Essentially, all models are wrong, but some are useful." - George E. P Box

Scooter57
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

Dividends' percent yields drop as the share prices are bid up. This is independent of the behavior of the underlying companies. Retirees desperate for income have pushed them way up these past few years.

bogleblitz
Posts: 331
Joined: Mon Oct 01, 2012 2:51 pm

### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

wbern wrote:
Now, all we’re left to calculate is the speculative return. Mr. Bogle, I think, would say that the historical yield should be 6%, so the doubling of the yield over the next 10 years should detract 7% pa from the return.

I'm a newbie. Reading this many times, and I still don't understand the speculative return. Why is it negative? how did 6% become -7%?

Does the S&P 500 index fund VTSMX have this -7% speculative return?

Valuethinker
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### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

bogleblitz wrote:
wbern wrote:
Now, all we’re left to calculate is the speculative return. Mr. Bogle, I think, would say that the historical yield should be 6%, so the doubling of the yield over the next 10 years should detract 7% pa from the return.

I'm a newbie. Reading this many times, and I still don't understand the speculative return. Why is it negative? how did 6% become -7%?

Does the S&P 500 index fund VTSMX have this -7% speculative return?

Yield is dividend/ price.

Say the price is 100 now and the yield is 3% so dividend is 3.

If the dividend yield doubled, back to historic levels of 6% say, then the price would drop to 50. That is called derating.

The thing with REITs is they distribute 90%+ of their profits (Earnings Per Share) by law.

So whereas for other equities we talk about PE ratios, the S&P500 is on 15 times say, having doubled from 8 times in 1980, and whether that can keep going or will it go back (in practice it went to well over 20X in 2000, and since then although profits have gone up and thus EPS, the PE has been falling pretty steadily, rebounding somewhat after 2009). But for REITs we talk about yields (dividend/ price, but in a REIT your dividends per share are pretty close to your earnings per share, because of the 90% rule). Yield going up is a fall in valuation, yield going down is a rise in price/ valuation.

But with REITs we say we are going to get the following sources of return

the existing yield 3%
+ likely growth in dividends say 3-4%
+/- rating or derating (a rise in the value the market puts on those dividends)

We have to factor in a 'derating' (rise in yields, fall in PE ratios) or a 'rerating' (rise in PE, like the S&P500 experienced 1980-2000, or a fall in dividend yields).

If we assume a derating of REITs back to 6%, that's going to hit your returns. Say it happens over 10 years, then by about -7% pa.

The counterargument to saying REITs will go back to historic 6-7% yields is that ALL assets have lower yields now, especially risk free bonds (and therefore everything else).

bogleblitz
Posts: 331
Joined: Mon Oct 01, 2012 2:51 pm

### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

Thanks Valuethinker for your explanation. REIT sounds just like Bonds, when interest rate rises, bond prices fall. When REIT yield rises, REIT prices fall.
I never heard of this before, I should really go back and read some investment books about REIT.

S&P500, reits, bonds all seems overpriced now.

Rodc
Posts: 11137
Joined: Tue Jun 26, 2007 9:46 am

### Re: How Would Mr. Bogle Calculate Expected REIT Returns?

If the dividend yield doubled, back to historic levels of 6% say, then the price would drop to 50.

Doesn't this suppose re does not get more profitable? If yield is down because rents are down (either per square foot when down or vacancy went up), and rents go back up, you could get a doubling of yield with no change in price. Or if folks are happy with a 3% yield they could bid prices up to \$200.

This would be like P/E10. It can be low because P is depressed or because E10 is high.

Long term with stocks you expect speculative returns to be zero. If high or low at the starting date you might not, but in general over say a lifetime of monthly investing you would expect something around zero.

Why would this not be true for REITS?

Fixed typo
Last edited by Rodc on Thu May 16, 2013 6:03 pm, edited 1 time in total.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.