Investors gunned the Dow Jones Real Estate index on Friday, jamming REITs up by 1.4% in the last 20 minutes of the trading day.  The index was actually flat at 2:45 pm before a wave of buying drove the index 2% higher into the weekend.

In our last post on REIT valuations, I noted that interest rates at the time supported REIT valuations.  However, I also noted that long-term bonds were excessively low, and that as interest rates normalized, REITs would become expensive again if prices did not fall. 

Since then, interest rates have risen.  The 10 year Treasury bond closed at a yield of 4.26%.  The dividend yield on the components of the Dow Jones REIT ETF, ticker IYR, is currently 5.27%. According to Merrill Lynch, the historical average difference between the dividend yield on REITs and the T-bond is 1.75%.  At a 175 basis point premium, the fair value of the IYR is $58.71, or 12.3% less than the current close of $62.73.  Assuming a 12.3% decline in the IYR, the ProShares UltraShort ETF, ticker SRS, which I own, an asymmetrical move would put the SRS at $112.  (The SRS replicates the index with futures and thus does move in perfect asymmetry.)

However, the year over year CPI print on Friday was a hot 4.2%, meaning the real return on bonds is zero.  Inflation fluctuates, but to return to a normalized real bond yield of 2%, either inflation has to fall to 2.2% or bonds have to rise to 6.2%. 

I have no idea where the T-bond is heading, but given that inflation fears are higher than they were a year ago, and that yields on the 10-year were above 5% a year ago, a 5% handle on the 10-year is not unreasonable.

A 5% yield implies a 22% decline on the IYR, putting the IYR at $52 while a similar move puts the SRS at $130.