Many investors seem to think that now is a great time to invest in treasuries (TLT; IEF).
Interest rates are at a 20-year-high, and you can finally earn pretty decent yields by simply holding these risk-free investments:
- 3-month treasuries offer a 5.37% yield
- 1-year treasuries offer a 4.99% yield
- 5-year treasuries offer a 4.23% yield
- 10-year treasuries offer a 4.28% yield
- 30-year treasuries offer a 4.48% yield.
That’s more than what most high-yielding sectors of the stock market are offering. Even real estate investment trusts, or REITs in short, are today only offering a 4.3% dividend yield on average (VNQ).
NAREIT
So why would you take the risk of investing in volatile companies like REITs when you could earn a higher and safer yield by investing in Treasuries?
That exact thought process has caused many investors to pull out of REITs to invest in Treasuries instead.
But I think that it is very shortsighted.
Here are three reasons why I believe that REITs are today far better investments than Treasuries:
Reason #1: Higher Cash Flow Yield
Yes, Treasuries often offer a higher dividend yield than REITs, but that’s by design because REITs retain a significant portion of their cash flow to reinvest in growth. Some REITs like SBA Communications (SBAC) and Boardwalk REIT (BEI.UN:CA) have payout ratios as low as 35%. It then isn’t surprising that they would only offer a low dividend yield.
Therefore, it is misleading to compare the dividend yield to the treasury yields.
What you should be focusing on is the cash flow yield because that’s what you are really earning as a shareholder.
REITs are today priced on average at 12.5x funds from operations, or FFO, which essentially means that they are offering an 8% cash flow yield (the inverse of 12.5x FFO). If the payout ratio is 50%, you will then get a 4% dividend yield, and the REIT will reinvest the other 4% for you, which will result in a higher share price over time. This is a good thing because it increases the tax efficiency of your investment since REITs pay no corporate tax on retained cash flow, and they also often enjoy great reinvestment opportunities for this cash flow. The REIT could, of course, pay out 100% of the cash flow if that’s what shareholders wanted. However, it would be less tax-efficient and leave the REIT with much poorer growth prospects, and this explains why most REITs retain a significant portion of their cash flow. In fact, REIT payout ratios are today historically low as most REITs would rather retain a larger portion of their cash flow since their cost of capital has gone up.
It does not change the fact that the cash flow yield of your investment is 8%, and that’s much more than what treasuries are today offering.
Yield | |
REITs | 8% |
Treasuries | 4-5% |
There is a huge difference between earning an 8% yield and a 5% yield. Over a 20-year period, $100,000 invested at 8% results in $466,095 but invested at 5% would only result in $265,329 — or nearly 2x less (and that does not even account for any additional growth that REITs may enjoy and the likely cut in interest rates, which will reduce the returns of treasuries and boost those of REITs).
So it is actually a misconception to think that treasuries are yielding more than REITs. It is the opposite.
Reason #2: Inflation Protection
The biggest issue with Treasuries is that they offer no protection against inflation.
Yes, their yield is historically high today, but that is only because inflation has surged. If you adjust for that, their real yields after inflation are nothing to celebrate.
The latest headline inflation came in at 3.3%. Remove that from the 5% treasury yield, and you are left with just a 1.7% real return.
Then remove taxes, and you are left with a ~1% real after-tax return.
That might be enough to preserve your purchasing power, but it is not enough to truly get ahead, which is the whole point of investing.
Sure, if you are a retiree with a short time horizon and a low-risk tolerance, then it makes sense to invest in treasuries, but for the vast majority of us, this is not very compelling.
Even most retirees still have a ~20-year investment horizon, and inflation can eat up a substantial portion of your capital over such a period.
REITs, on the other hand, enjoy strong inflation protection since most of them own real assets that are essential to our society. Think about the e-commerce warehouses of Prologis (PLD) or the apartment communities of AvalonBay (AVB) or even the grocery stores of Federal Realty Trust (FRT).
Federal Realty Trust
AvalonBay
These properties are limited in supply, growing in demand, and their construction cost is only going up with inflation and higher interest rates. Therefore, it only accelerates rent growth, and this explains why REIT cash flows and dividend payments kept growing in 2022, 2023, and 2024.
So you are not just getting the 8% cash flow yield. You are also getting growth on top of that.
Assuming that rents grow by 3% per year on average, that would get you to 11% annual total returns. This is in line with what REITs have achieved over the long run, and it is far more than what Treasuries can offer you:
REITs
The trade-off for REITs is that they can be a lot more volatile and can face greater downside risk. The recent 2-year-long bear market is a good example of that.
However, if you have a long time horizon, this increased volatility is generally worth it. REITs have gone through countless crises and market crashes in their history, and yet, they have always eventually recovered and richly rewarded their shareholders:
NAREIT
Reason #3: Significant Reinvestment Risk
But this is probably the most important problem of Treasuries today.
Interest rates are very likely to be cut in the near term.
They were hiked at an unprecedented pace to fight off the high inflation, but it has already moderated since then, and the Fed has made it clear that interest rates will return to lower levels in the near term.
Today’s high interest rates simply won’t be needed as inflation cools down, and let’s face it, with $34 trillion of public debt, we cannot afford it anyway.
Canada, the Eurozone, Switzerland, and Hungary already announced their first interest rate cut and it is widely expected that the US will soon follow. Debt markets are today pricing ~125 basis point lower interest rates within a year from now:
Fed Watch Tool
This means that the current yields of Treasuries are likely nothing more than a mirage. You may think that you will consistently earn a 5% yield by investing in short-term Treasuries. However, the actual yield that you will receive is expected to be quite a bit lower since interest rates could be cut in the near term. Your interest rates are only locked for a short period because your 3-month Treasuries will need to be rolled at lower and lower yields as interest rates are cut, resulting in a lower annual yield in the end.
Moreover, once interest rates are cut, other investments like REITs will likely surge to higher levels. Quite a few REITs are down 30-50% because the surge in interest rates caused them to go out of favor, but as interest rates are cut, they could recover just as fast as they dropped. This is especially true since their cash flows and dividends have kept on rising and are at an all-time high.
This means that you are today giving up on substantial potential gains and facing significant reinvestment risk for the safety of treasuries. Eventually, you will likely want to reallocate your capital elsewhere if interest rates are cut to lower levels, but by then, other investments like REITs will likely be a lot pricier.
That’s a big price to pay.
So to recap:
REITs offer a much higher cash flow yield. It is today 8% on average, but there are many REITs that trade at a 10-15% yield. EPR Properties (EPR) is a good example. It is an investment-grade-rated REIT with steady growth prospects, and it is currently offered at a 12% cash flow yield.
Moreover, REITs enjoy inflation protection. EPR has guided for 4% growth in 2024, and recently, it also hiked its dividend by 3.6%.
Finally, REIT investors will likely see their income rise even as treasury investors see their income decline in the near term. Moreover, REITs are also likely to surge in value, which means that treasury investors are also running significant reinvestment risk.
With REITs trading at their lowest valuations in over a decade, I think that the choice is easy. REITs are much better investments today for the vast majority of investors in my opinion.
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