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, (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, (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.