By contrast, over the same time period, the S&P 500 with dividends had a cumulative return of 10.0%, punctuated by annual returns ranging from a high of almost 29% in 2003 to a low of -37% in 2008. While predicting future returns of the MFSI and the S&P 500 is impossible, the spread between the dividend yield available on the MFSI and on Treasury securities is informative. That spread is now suggesting that the MFSI may move still higher, going forward.        

Historical Review

In January 2002, the NAHB introduced the MFSI to help the multifamily industry and investors better track the performance of public firms principally involved in multifamily ownership and management, and to allow for comparisons between the MFSI and other major stock indices. In order for meaningful historical comparisons to be made, we set the starting point for tracking the performance of all the firms that qualified for inclusion in the MFSI at December 31, 1998. 

Since then, the MFSI has increased by slightly more than 157%, for a compound rate of return of 8.9% per year. During the same 11 years, the S&P 500 with dividends reinvested increased by slightly more than 10%, for a compound rate of return of about 1% per year. In other words, since December 1998, the compound rate of return for the MFSI has been about nine times higher than for the S&P 500 with dividends reinvested. As a result, $1,000 invested in the MFSI at the end of 1998 would now be worth $2,574 but worth only $1,100 had it been invested in the S&P 500 with dividends reinvested.

Year-End Review

Over the past 12 months, the MFSI and the S&P 500 with dividends reinvested enjoyed very similar rates of return. The MFSI returned almost 31%, while the S&P with dividends reinvested posted a return of slightly better than 26% — a difference of about five percentage points. The year began with the MFSI 126% higher than the S&P 500, and while that margin fluctuated between January and December, it was never that high again until December. It now stands at 134%. 

Despite the recent gains, what is most impressive is that despite numerous negative shocks to the economy — including a severe credit crunch, continued house price declines, persistent job losses, wild fluctuations in the price of energy and a sharp decline followed by a partial recovery in equity values — the MFSI and the S&P 500 with dividends reinvested have moved pretty much in lock step, and have both performed well. During 2009, the MFSI declined in the months of January, February, June and October, while the S&P 500 with dividends reinvested declined in January and February, was flat in June, and declined in October.         

Another Look at History

The very different historical rates of return exhibited by these two indices can be seen by looking a Figure 1. It shows that the performance of the MFSI can be roughly split into two main periods: December 1998 through the end of 2006, and from the start of 2007 through to the present. During the first period, the performance gap between the two indices continually widened, with very few exceptions. In particular, from the end of May 2000 through September 2002, during a severe bear market, the S&P 500 declined by about 40% while the MFSI increased by almost 20%. From September 2002 through the end of 2006, the MFSI continued to outperform the S&P 500, but by a much smaller amount.     

Since the end of 2006, however, the gap between the two indices has narrowed considerably, primarily due to a substantial decline in the MFSI. Since the start of 2007, the MFSI has declined by 33.1% while the S&P 500 has fallen by only 17.2%. Since October 2007 when the S&P 500 peaked, it has fallen by 24.2%.          

Figure 2 looks at the same data, but reports only the level of the indices on the last day of each year for each of the past 11 years. Here the divergent growth rates exhibited by the MFSI and the S&P 500 are even more pronounced. While the indices moved in tandem through 1999, over the next three years the S&P 500 continually fell while the MFSI held steady around the 1,500 point mark. As a result, the performance gap between the two indices grew very large by the end of 2002. From then through the end of 2006, the gap grew still larger, but both indices went up — the MFSI by 133%, and the S&P 500 with dividends reinvested by about 85%. Since the start of 2007, however, the MFSI has performed relatively poorly, falling from roughly 3,850 to about 2,600. 

These results are further explained by looking at Figure 3, which shows the 12-month rate of return for each index over the past 11 years. For the years ending Dec.ember 31 2000, 2001 and 2002, the MFSI dramatically outperformed the S&P 500, but in only the first of these three years did the MFSI post a significantly positive return. In the latter two years the MFSI was virtually stagnant, while the S&P 500 suffered declines of roughly 10% and 20% respectively. 

For the four years ending December 31, 2006, both indices had positive returns in each year, with the S&P 500 slightly outperforming the MFSI during 2003 and the reverse being the case in 2004, 2005 and 2006. Note that the MFSI dramatically outperformed the S&P 500 in both 2004 and 2006.    

Since the start of 2007, however, things have been much more volatile. In 2007, the MFSI had a dreadful year, declining by almost 25%. Moreover, it did so while the S&P 500 posted a solid 5.5% return. In 2007, not only did the MFSI end the year in the red for the first time since 2002, it more importantly significantly underperformed the S&P 500 for the first time since 1999.  In 2008, both the MFSI and the S&P 500 did very poorly with the MFSI falling by 26% and the S&P 500 by almost 50% more, or 37%. Interestingly, 2009 has turned out a lot like 2003, a year when all three indices scored gains of greater than 20%. For the 12 months ending December 31, 2009, the MFSI was up 30.7 percentage points while the S&P 500 gained 26.5%.

Lastly, from a chartist perspective it is interesting to note that there appears to be a four-year cycle at work. To be specific, in year one of the cycle (1999, 2003, and 2007) the S&P 500 outperforms the MFSI, but then for the next three years of the cycle the roles are reversed. This cyclical history suggests that the MFSI should outperform the S&P 500 in 2010.             

Relative Interest Rates and Performance

While the performance of the MFSI may be attributable to a number of factors, one likely explanation for at least part of its performance involves interest rates — in particular, the difference between the interest rate on U.S. Treasuries and the dividend yield available for the MFSI. The dividend yield is defined as the annual dividend per share divided by the price per share. The means that when share prices increase (decrease) dividends yields fall (rise). Over the past decade or so, the spread between these two yield measures has changed dramatically, and those changes offer potential clues into the future performance of the MFSI.          

Figure 4 charts the dividend yield of the MFSI as well as the interest rate on 1-Year, 5-Year and 10-Year Treasury securities over the past 11 years. While the rates for all three Treasury securities have not moved in lock-step, from December 1999 through early 2003, yields on Treasury securities declined steadily while the yield of the MFSI slowly drifted upwards. As a result, by early 2003 the yield spread, which was negligible in 2000 ranged from 6.5 percentage points on 1-Year Treasuries to 4% on 10-Year Treasuries. This increasingly large difference may well have been part of the reason the MFSI defied the bear market of 2001 and 2002.  

Starting in early 2003 and extending through very early 2007, yield spreads between Treasuries and the MFSI reversed themselves. Over that roughly four-year time period, Treasury yields consistently increased while there was steady erosion in the dividend yield of the MFSI. The most pronounced increase occurred in the 1-year Treasury note, which increased from a low of 1.01% in June of 2003 to 4.96% in July of 2007. Over the same time period, the 5-year Treasury increased from a low of 2.27% to 5.03%, while the 10-year went from a low of 3.33% to 5.10%.

Figure 4 also shows that the dividend yield on the MFSI was very high near the end of 2002, when it briefly hit a then-record 7.96%. From then through January 2007 it steadily declined to a low of 3.09% — not coincidentally, precisely when the MFSI was at its peak. 

The prolonged rise in Treasury rates coupled with the near simultaneous decline in the dividend yield of the MFSI was such that over that approximately four-year period, the interest rate spread between the dividend yield of the MFSI and the 10-year Treasury bond went from positive 4.02% in October 2002 to zero in January 2006 (where all four lines intersect for the first time), to negative 1.67% in January of 2007 — a change of 5.69 percentage points. The change in the interest rate spread between the MFSI and shorter-term Treasury securities was even larger.¹

In early 2007 this relationship reversed again. Since then, the dividend yield of the MFSI has risen from a low of 3.09% in January 2007 to 7.06% in mid-2008, and briefly to an all-time high of slightly more than 16% in early 2009. It now stands at 6.3%. At the same time, the yield on the 10-Year Treasury fell from 4.76% to its current rate of 3.59%, but not before reaching a historic low of 2.42% during December 2008. As a result, the spread between the two has swung from -1.67% in January 2007 to 2.96% in June 2008 to 2.75% today — a swing of almost 4.5 percentage points. With the exception of the past 12 months, this approaches the all-time high set in early 2003. Note that the dividend yield during February and March of 2009 was about twice as high as its previous all-time high of 7.96% set in October of 2002.

While rising interest rates affect the entire economy, their effect on homebuilding and real estate is disproportional. For smaller builders, rate hikes make construction financing more costly. Similarly, multifamily developers see higher rates reducing profit margins, since more must be spent on financing, which in turn reduces dividends. By contrast lower interest rates increase profits.     

Interest rate changes also alter corporate valuations. Given the generally low interest rate environment of the last few years, the high dividends available on REITs were very attractive to an unusually broad class of investors.  However, given the magnitude of the changes in the yield spreads between Treasuries and the MFSI, it is hard to imagine them not exerting some impact on MFSI performance. Figure 5 compares the performance of the MFSI (in gray and on the right hand axis) to the yield spread between the MFSI and the 10-year Treasury bond (in black and on the left hand axis). The results are striking. 

Traditionally, as long as the yield spread is positive (the area shaded in dark gray) the MFSI generally does well. By contrast, when the yield spread is negative (the area shaded in light gray), the MFSI generally moves sideways. However, these historical relationships were clearly broken starting in very late 2007, which neatly coincides with the start of the current recession and the severe credit crunch (which for a time made it quite difficult for REITs to refinance).

This analysis suggests two things: the performance of the MFSI and the spread between the MFSI and Treasuries may be an economic indicator; and the recent and dramatic uptick in the performance in the MFSI may be suggesting that the historic relationship between yield spreads and performance has returned. To the extent this is true, the MFSI may continue to experience price appreciation. As a result, particular attention to the earnings of residential REITs and the yield spread between it and Treasuries may be in order.  

Conclusion

Over the past 11 years the MFSI has dramatically outperformed the market as a whole, as measured by the S&P 500 with dividends reinvested. However, the relative performance of the MFSI has not been consistent. Between March 2000 and September 2002, and again between August 2004 and January 2007, the relative performance of the MFSI compared to the S&P 500 with dividends was outstanding.  

By contrast in 2007and 2008 the performance of the MFSI slipped. During that time it posted its first ever back-to-back negative returns and its worst one-year decline ever. Traditionally, at least part of the explanation for this poor performance would have been that the yield spread between the MFSI and the 10-year Treasury had grown unfavorably large and thus acted as a strong headwind. However, over the past few years the spread between the yield on the MFSI and U.S. Treasuries has been very favorable. As a result, the superior performance of the MFSI in 2009 is not surprising as it is merely a return to a relationship that is long-standing. This suggests that during recessions, this relationship is weakened – and when recessions end, the MFSI regains its winning ways.          

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