A Broad, Low-Cost REIT ETF for a Low-Rate Environment

Throughout 2014, interest rates have defied many expectations to the contrary by declining. That's been good news for the United States REIT space, which has performed well this year.

Right now, Morningstar's equity analysts believe that the U.S. REIT sector as a whole is slightly overvalued. However, our analysts also see pockets of opportunity in certain areas of the REIT landscape, including health care, retail, and cell tower properties. Traditionally, shares of REITs move inversely with changes in long-term government-bond yields, and REITs likely will underperform in a rising-rate environment.

For REIT investors who are skeptical that rates will rise anytime soon, one exchange-traded fund that offers an excellent and low-cost way to gain access to the U.S. REIT sector is  Vanguard REIT ETF (VNQ). Far and away the largest U.S. REIT ETF, VNQ holds equity REITs, which manage commercial properties and collect rent. Because most REIT ETFs have very similar holdings, expense ratios are a particularly important consideration when choosing a fund. VNQ's 0.10% expense ratio makes it one of the cheapest options available. Its market-cap-weighted portfolio contains 138 holdings, which represent almost all of the real estate sector's total market capitalization. The fund holds a healthy dose of mid- and small-cap stocks (mid- and small-cap stocks make up 34.5% and 19% of the portfolio, respectively). These small firms make up a relatively small component of the total portfolio but help diversify the fund. This fund's low-cost and diversified exposure to the domestic real estate market make it a suitable ETF for most investors.

REITs have traditionally been viewed as a liquid way to buy commercial real estate and a portfolio diversifier, but the sector's investor base has expanded in recent years to include income- and growth-seekers. REITs usually yield more than the broad equity market because of their legal structure: To qualify as a REIT, a real estate firm must pay out 90% of its taxable income to shareholders as dividends. This income is exempt from corporate-level taxation and passes directly to investors. In the years following the financial crisis, this high level of income has become popular with income investors dissatisfied with the low rates on fixed income. VNQ yields 4.1% today, which is almost 2 full percentage points higher than the S&P 500.

Although REITs offer relatively attractive yields, they are still equities and are not a suitable alternative to low-risk investments such as Treasuries. Over the past three years, REITs were about 41% more volatile than the S&P 500 Index and 5.5 times more volatile than the aggregate U.S. bond market. Potential near-term risks include slower-than-projected growth, setbacks in the U.S. economy, and rising interest rates. The fear of rising rates proved to be a significant headwind to the sector in 2013, but investors' bullishness returned in 2014, as they became less concerned about any imminent rate hike.

Fundamental View
Since the economic downturn, REITs have benefited from two important forces. Interest rates have stayed low, and with slow and steady growth in the broader economy, developers haven’t roared back with a massive influx of new supply in the marketplace. As a result, incremental demand from a slowly improving economy has accrued to existing landlords in the form of higher occupancies, higher rental rates, and solid same-store net operating income growth. REITs also have taken advantage of the low rates to refinance existing debt, and property valuations have risen. In some respects, the past six years have provided a perfect positive storm for REITs.

Interest rates undoubtedly will rise at some point, and higher interest rates remain the REIT sector's greatest potential headwind. As rates rise, REITs' interest payments go up, which means REITs have less cash flow available for dividends for equity investors. As a result, higher rates mean both higher interest expense and less business reinvestment. Not surprisingly, REITs with lots of debt and higher levels of near-term maturities--which would need to be refinanced--will fare worse than REITs with less debt and long-dated debt maturity schedules. Due to most REITs' well-laddered and lengthy debt maturity schedules, it would take years for a sharp increase in interest rates to be fully incorporated into REITs' earnings. Nonetheless, REITs with relatively modest levels of leverage and low debt service relative to cash flows generally should fare better in a rising-rate environment.

While higher interest rates should affect the entire REIT industry, its subsectors would be affected differently, depending on lease durations. REITs with shorter lease durations likely would fare relatively better in a rising-rate environment because they would be able to go back to tenants as rates rise (especially if it's due to inflation) and ask for higher rents more frequently than can the REITs with longer lease durations. And higher rents could somewhat offset the negative impact of higher interest expense. Generally, hotels have the shortest lease durations in the REIT space, followed by multifamily properties. After that, from short to long, the other subsectors are self-storage, industrials, retail, office, and health care. VNQ's portfolio has significant exposure to the REITs that would be expected to get hit hardest, such as health care, office, and retail. At the same time, VNQ holds fewer REITs with the shortest lease durations and more with longer lease durations. REITs with short lease durations appear more richly valued right now than the rest of the REIT universe and seem to be operating near peak levels. Thus, while REITs with short lease durations may be more able to adapt their operations to interest-rate hikes, they also are offering investors less of a margin of safety at present.

VNQ dramatically underperformed in 2013 as investors worried about higher rates. However, the fund has roared back in 2014, more than doubling the S&P 500 Index's year-to-date return as investor worries over immediate rate increases were allayed. While investors may have acclimated to the shock of the Fed's potentially winding down quantitative easing, they also might have short-term mindsets and be simply relieved that interest-rate hikes have continued to be postponed. In any case, rising rates don't happen in a vacuum. Higher rates frequently take place when the economy is strong, and REITs are cyclical businesses. What investors should fear most is the prospect REITs getting hurt by rising rates but then not helped by a corresponding lift in the economy driving occupancy and rate increases on tenants. Historic evidence demonstrates that economic growth also is a key driver of REIT performance.

Portfolio Construction
VNQ tracks the MSCI US REIT Index, which includes all domestic REITs from the MSCI US Investable Market 2500 Index, which imposes minimum liquidity and size requirements. Constituents are weighted by their free-float-adjusted market cap. Mortgage REITs and non-real-estate specialty REITs (such as timber and prisons) are excluded. The index is reviewed semiannually and rebalanced quarterly. The fund's portfolio is diversified across property sectors. Retail REITs are the largest holding, at 26% of assets. Office, residential, and health-care REITs take up between 13% and 17% each. Diversified (10%), hotel & resort (8%), and industrial (5%) REITs are also represented. VNQ's sector holdings are not meaningfully different from its category average. Prior to May 2009, the fund tracked an adjusted version of the index that included a 2% cash position. Since then, cash accounts for less than 1% of the fund's assets. When possible, REITs should generally be held in a tax-deferred account. Most of their distributions are taxed as ordinary income and don't benefit from the low 15% qualified dividend rate.

Fees
This fund charges 0.10%, which is significantly less than the fees charged by almost all competitors. Its estimated holding cost, which measures the difference in performance between an ETF and its benchmark, is 0.06%. VNQ tracks its index almost perfectly, lagging by less than its expense ratio over the past five years. When possible, REITs should generally be held in a tax-deferred account. Most of their dividends are taxed as ordinary income and don't benefit from the low 15% qualified dividend rate. The unfavorable tax treatment arises from the REIT legal structure, which, in exchange for no taxation at the company level, obliges the firms to pass on the vast majority of their earnings to shareholders.

Alternatives
Only  Schwab US REIT ETF (SCHH) can challenge VNQ's low price. It charges just 0.07% for a very similar portfolio, with an 84% holdings overlap. We prefer VNQ's broader selection of REITs, but SCHH is an excellent alternative.

 SPDR Dow Jones REIT ETF (RWR), which charges 0.25%, tracks the same index as SCHH but charges fully 18 basis points more. While RWR has tracked its index closely, its performance lags that of SCHH by the difference in their expense ratios, and the difference in liquidity between the two ETFs is minimal. As a result, investors interested in RWR should take a close look at SCHH.

 IShares US Real Estate (IYR) is the only large REIT ETF whose index allows it to own all REITs. Most indexes exclude REITs that derive the majority of their income from non-real-estate activities, a category that contains mortgage, prison, and timber REITs. IYR includes these REITs, which make up about 20% of its holdings. These firms are exposed to economic factors other than the real estate market. IYR is expensive at 0.43% a year. With inexpensive alternatives to choose from, this fee is difficult to justify.

Investors who want to buy only the largest REITs might consider  iShares Cohen & Steers REIT (ICF), which tracks the 30 largest REITs. It costs 0.35% a year.

The small-cap segment of the market is tracked by IQ U.S. Real Estate Small Cap ETF (ROOF), which costs 0.69% a year. Pure mortgage REIT exposure is available through  iShares Mortgage Real Estate Capped ETF (REM), which charges a 0.48% expense ratio.

 

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