WPC - REITs Vs. 5%+ Yielding Money Markets

2023-10-12 08:05:00 ET

Summary

• REITs are priced at the lowest valuations in years, but investors aren't buying them.
• Many are avoiding them simply because they believe that money market funds offer an attractive alternative.
• We explain why this makes little sense.

Co-produced by Austin Rogers.

Why would I buy a REIT when I could keep my money in a risk-free money market yielding over 5%?

We hear that question all the time, over and over again.

We don't blame investors for thinking this way. Truly, we don't. Income-oriented investors especially are prudent to think primarily about capital preservation and the safety of the income stream. Money markets offer both.

But we think that many investors are thinking about the "REITs vs. money markets" debate all wrong right now. There is far more to consider besides just the annualized yield.

• Money markets are fundamentally short-term investments and savings vehicles useful for preserving capital value.
• REITs are fundamentally long-term investments useful for generating a growing income stream and strong total returns over time.

We think that simply understanding this difference proves the "REITs vs. money markets" idea a false dichotomy. One can and should have some amount of cash in money markets, but there is no reason not to simultaneously use other money to invest in heavily discounted real estate investment trusts or REITs.

The Standard Personal Finance Wisdom

Let's say you have just received your first paycheck ever and are thinking about what to do with it. The standard suggested order of destinations for that cash goes something like this:

• Pay your living expenses
• Pay off debt
• Build up short-term savings
• Invest in long-term assets in a tax-advantaged account
• Invest in long-term assets in a non-tax-advantaged account.

Of course, there is a lot of nuance that we are skipping over here, but this is the generally accepted order of what to do with your money, according to personal finance experts.

Let's assume your income is more than enough to cover your living expenses and all debt you may have once had is now paid off (except, perhaps, your home mortgage). Many personal finance experts would now recommend building up a short-term savings buffer outside a non-retirement account to cover any emergency expenses or normal living expenses in the case of a job loss.

Money markets are ideally suited to act as this non-retirement, emergency savings account. Money markets are insured by the SIPC ("Securities Investor Protection Corporation") for up to $500,000, and they generally offer higher yields than FDIC-insured bank savings accounts.

Younger people with stable employment can perhaps get away with only a few months' worth of living expenses stashed away in a savings account or money market. On the other end of that spectrum, retirees may want to have a year or more of cash in money markets because of their lack of employment income.

This is the value of a money market. It provides stability, as shares of money market funds are set at $1. And when the Fed raises its key policy rate, the interest generated from money markets rises with it.

Look To The Horizon

When the Fed Funds Rate is over 5%, as it is now, money markets will likewise yield over 5%. During those times, it can be tempting to view money markets as a better place to store one's incremental dollar than a REIT yielding, say, 4-5%.

For virtually all of 2023, money markets have offered a higher yield than REITs, represented below by the Vanguard Real Estate Index Fund ETF Shares ( VNQ ):

But here it is vital to differentiate between short-term savings and long-term investments .

If your short-term savings are adequate for your goals/needs, then the better use of your incremental dollar is to apply it toward some sort of long-term investment.

In other words, if the choices are money markets or REITs, you would probably be best suited to put your incremental money toward REITs once your short-term savings are adequate.

The reason for this is simple: a money market's yield is temporary, while a REIT's yield is (ideally) permanent and comes with growth.

We can demonstrate this by comparing the dividends of a standard money market -- the Vanguard Federal Money Market Fund Investor Class ( VMFXX ) -- to a standard REIT -- Realty Income ( O ).

If you came across a stock paying a dividend this erratic and prone to huge swings, most investors wouldn't touch it with a 10-foot pole. And yet, when it's a money market, income investors seem not to think or care about the distribution variability.

When the Fed raises its policy rate, the dividends from money market funds immediately go up, starting the very next month. But when the Fed lowers the interest rate, money market dividends immediately go down with it.

On the other hand, O's dividend kept steadily rising over time, even through the Great Recession of 2008-2009 and the COVID-19 pandemic of 2020-2021.

Now, you might accuse us of cherry-picking here. After all, many REITs had to cut their dividends during the Great Recession as well as during the COVID-19 pandemic.

But that is why we don't invest in REIT ETFs like the VNQ. We literally do cherry-pick what we view as the best REITs with the most total return potential and/or dividend safety, depending on one's goals.

The point here is that, if you have done your due diligence and invested wisely, the income investor would do far better in the long run by dedicating the incremental dollar (beyond one's savings needs) to REITs rather than money markets.

Look to the horizon -- that is, to your investment horizon.

Do you need to use this money for something in the next few years, such as a new car or a down payment on a house? Or do you need to have increased money set aside for plausible expenses, such as a healthcare bill or vacation? If so, then a money market is your best bet.

But if you know you don't need this money (except whatever income it generates) back for 3-5 years or more, then it is better to allocate it toward a long-term investment like a REIT.

The Illusion of Money Markets' "5% Yield"

We will go even further.

It isn't just that over the long run , you'd be better off enduring the volatility of long-term investments such as REITs. Even that juicy, risk-free 5% yield you see being offered by money markets could be illusory.

The 5% annualized money market yield assumes that the Fed Funds Rate ("FFR") will remain above 5% for at least one year. But what if it doesn't? What if the Fed cuts the FFR sometime in the next year?

In the last several decades, whenever the FFR and money market yields have reached above 5%, they have not stayed at that level for very long.

Imagine if you'd put your money into a money market at the very beginning of 2008, when it offered a yield of 5%, and left it in there for a full year. We all know what unexpectedly happened in 2008. The financial markets crashed, and the Fed cut rates.

As a result, that nice 5% yield you thought you were getting at the beginning of 2008 turned out to be much lower over the course of a full year.

The average dividend yield shown in the chart above uses trailing twelve-month dividends, but if you annualized each month's dividends and averaged them out over the full year, the effective yield you would have received on the money market fund would have been about 3%.

Why Not Wait In Money Markets Until Rates Fall?

Some investors, understandably wishing to avoid potential further downside and volatility, will decide just to wait out the current REIT bear market in a money market fund until the Fed finally does lower interest rates, at which point they will buy REITs.

Admittedly, if one had implemented this strategy in 2008-2009, it would have worked remarkably well.

By waiting until the FFR had dropped all the way to zero before moving one's cash from money markets into REIT shares, one would have been able to purchase REITs at around half the price they could have in early 2008.

The problem is that investors think that this pattern will play out the exact same way every time. But it doesn't. The Great Recession of 2008-2009 was uniquely bad for REITs. Sentiment about any type of real estate was ultra-low and leverage was high.

Most economic forecasters who see a recession on the horizon believe it will be milder, more akin to the shallow recession of 2001 than the deep recession of 2008-2009.

During the 2001 recession, if an investor hid out in money markets until the Fed dropped rates to zero, they would have had to pay a much higher price for REITs than if they had bought REITs when money market yields were at their peak.

Compare the two following charts, covering the exact same period from the beginning of 2000 through the end of 2002:

If you had bought these three REITs at the beginning of 2001, when money market yields were at their peak, you would have gotten lower prices and higher dividend yields.

Here is the difference in dividend yields between the three REITs in January 2001 (when money market yields were at their peak) and March 2002 (when money market yields had slumped to nearly zero):

How and why did REIT prices rise through a recession? For two reasons:

1. It was a "garden-variety" recession, and
2. Interest rates dropped, reducing REITs' cost of debt and making their yields more attractive compared to bonds and money markets.

Timing the markets can be a perilous endeavor. Sometimes it pays off, but most of the time it doesn't.

Any investor who kept their money in a money market fund in 2008-2009 until the FFR bottomed and then bought REITs got very lucky. But how do you know the next recession won't be more like 2001 when REIT stocks rallied because of falling interest rates?

Bottom Line

The bottom line here is that REITs and money markets are two different types of investments for different purposes.

If you are investing for some short-term use of the funds, then money markets are almost certainly the better place to put your money.

But if you have adequate short-term savings to handle emergency expenses, paying bills during an unexpected layoff, and giving peace of mind through stock market volatility, then the better use of each available incremental dollar is most likely long-term investments like REITs.

We believe there are some phenomenal buying opportunities in the REIT space right now, and we are taking advantage of them ourselves. But we do not advocate raiding your short-term savings or violating sound personal finance principles to do so.

So, the question of "REITs vs. money markets" is a false dichotomy. We emphatically say: "Both!"

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