Before the recent turmoil on Wall Street, share prices of the publicly traded multifamily companies tracked by the NAHB for its Multifamily Stock Index (MFSI) performed incredibly well, with a cumulative return of 230% since December 1999. That long run of success, however, might be coming to an end.

The combination of historically very low dividend yields for the MFSI and the increasingly attractive interest rates available on Treasury securities suggests that the MFSI is unlikely to perform as well in the near future as it has in the past. In fact, the MFSI looks to end the year in the red for the first time since 2002, and may significantly underperform the S&P 500 for the first time since 1999.

A possible explanation for part of the recent decline in the MFSI may be the prolonged and steady rise in interest rates, coupled with the near simultaneous decline in the index's dividend yield. (The dividend yield is the annual dividend per share divided by the price per share.) As a result, as share prices rise, dividends yields fall. And because the MFSI performed so well over the last eight years or so, its dividend yield is now very low.

The chart below shows the dividend yield of the MFSI and the interest rate on the 1-year, 5-year and 10-year U.S. Treasury securities since December 1999. 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.

Interest rates also alter corporate valuations. Given the historically low interest rate environment of the last few years, the high dividend yields on real estate investment trusts have been highly attractive to a broad class of investors.

But the size of the change in the yield rate spread between Treasuries and the MFSI is very likely exerting some impact on MFSI performance. When examining MFSI performance to the yield spread between the MFSI and the 10-year Treasury bond, the results are striking.

As long as the yield spread is not much worse than negative 1.5%, the MFSI appears to not be adversely affected. By contrast, when the yield spread exceeds that amount, the performance of the MFSI deteriorates. With that in mind, particular attention to the earnings of residential REITs and the yield spread may be in order.

At least part of the explanation for this may be that the lower yield spreads are acting as a strong headwind, discouraging investors who in the past chose multifamily REITS specifically because of their relatively high dividend yields. Combined with the REITs' now relatively high share prices, those lower dividend yields may have investors taking a closer look at alternative investments.

Editor's Note: In January 2002, 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 comparisons between the MFSI and other major stock indices. So that meaningful historical comparisons might be made, NAHB set the starting point for tracking the performance of all the firms that qualified for inclusion in the MFSI at December 31, 1998. (You can view companies currently being tracked at www.nahb.org/multifamily.)