An ETF Pick for Those Looking to Tap Into Foreign Real Estate

Vanguard Global ex-U.S. Real Estate ETF

VNQI is a sound choice for broadly diversified, low-cost exposure to foreign real estate securities. This fund tracks a broadly diversified, market-cap-weighted index that is representative of the opportunity set available to investors in this market segment. It also has a durable edge over peers in the form of its lowest-in-class expense ratio. That said, the fact that its benchmark omits U.S. securities and includes emerging-markets ones make it a misfit in a field dominated by more globally oriented peers. Also, its emerging-markets exposure has translated to significantly higher risk than most funds in the global real estate Morningstar Category. It earns a Morningstar Analyst Rating of Bronze.

REITs make up about 45% of the fund's portfolio. REITs must distribute the majority of their taxable income to shareholders. Its remaining holdings are engaged in a diverse array of real estate-related activities and include real estate operating companies, real estate developers, and non-REIT property managers. Developers construct buildings on new or underutilized land. Unlike REITs, which are restricted from building in some nations, developers can take on more-speculative projects. Developers are more volatile than REITs because their cash flows are less predictable, and payout ratios are generally much lower.

The fund also holds a meaningful stake (about 20%) in emerging-markets firms. Over the long term, emerging-markets real estate firms should benefit from rising incomes and consumer spending, which will drive demand for high-quality spaces, slowly boost rents, and increase occupancy rates. Growth in shopping centers and office space should provide a lift for commercial real estate firms and REITs.

The fund invests about 50% of its assets in companies operating in the Pacific region, including 23% in Japanese real estate firms and another 8% in Australian real estate firms. As it has major exposure to these geographies, investors should be cognizant of the outlook for interest rates and growth in these regions.

Fundamental View How real estate is owned in public markets varies by geography. The REIT structure is common in mature real estate markets where there is generally less property development, such as the United States, Japan, and Australia. However, in much of Asia and in other emerging markets, real estate firms more commonly use different corporate structures.

REITs make up about 45% of the fund's assets. That's a lower percentage than what's found in other foreign or global real estate funds, in part because this fund has a larger allocation to emerging-markets real estate firms than peers. Regardless of corporate structure, however, foreign real estate firms have some aspects that are similar to U.S. REITs. In both cases, they buy, manage, and sell properties. And foreign real estate firms' volatility profile, in aggregate, is similar to that of U.S. REITs.

There are some significant differences between the U.S. real estate asset class and its foreign counterparts. U.S. interest-rate movements are U.S. REITs' single largest driver, while local interest rates and property development drive foreign real estate firms. Also, largely because the REIT structure requires firms to pay out at least 90% of their taxable income to shareholders, U.S. REITs' payouts are higher than foreign real estate companies' payouts.

REIT returns come from both rental income (which is a combination of occupancy rates and rental rates) and property appreciation. Through leverage, REIT firms have the potential to provide investors with higher returns than their underlying assets over and above simple capital gains. The REIT structure is most common in the U.S. but has gained traction overseas.

Unlike U.S. real estate funds, which are almost entirely composed of REITs, about 55% of this fund's portfolio is invested in real estate developers and non-REIT property managers. Developers focus on constructing spaces on new or underutilized land. REITs are restricted from breaking new ground in some countries, but property developers can take on more-speculative projects. Developers are more volatile than REITs because their cash flows are less predictable and their payout ratios generally are lower.

Portfolio Construction The fund tracks the S&P Global ex-U.S. Property Index, a broad, market-cap-weighted benchmark containing international property companies. This benchmark effectively diversifies risk and accurately reflects the composition of its target market, supporting the Positive Process Pillar rating. Constituents must meet size and liquidity requirements and are weighted by their float-adjusted market cap. To qualify, firms must be classified under the GICS real estate industry group, meaning they specialize in real estate development or management. The index includes real estate firms that are not structured as REITs, but homebuilders and real estate agents are excluded. The fund has more than 630 holdings, substantially more than any other international real estate index fund. The fund uses full replication to track its benchmark, owning virtually every security in the index in approximate proportion to its index weighting. Vanguard equitizes any cash balances with futures contracts and they have a zero target on the portion of the cash balance that isn't equitized.

Fees The fund's Institutional, Admiral, and exchange-traded fund share classes charge respective fees of 0.13%, 0.14%, and 0.14%. These are the lowest-cost options of any mutual funds and ETFs in the global real estate category, supporting the Positive Price Pillar rating. Because this fund invests in foreign companies, a portion of its distributions could be subject to foreign withholding taxes. If the fund is held in a taxable account, investors can file for tax reimbursement, but if the fund is held in a tax-advantaged account, the foreign taxes cannot be recouped. Because real estate distributions are rarely considered qualified dividend income, only minimal percentages of the fund's distributions have been deemed qualified in recent years.

Alternatives

There is a limited menu of ETFs focused on foreign real estate. The next-largest foreign real estate ETF as measured by assets under management is

The only other international REIT ETF with an appreciable amount of assets under management is iShares International Developed Real Estate IFGL. The fund charges an annual fee of 0.48% and has similar country and subsector weightings to VNQI but holds no emerging-markets firms and is more concentrated than VNQI.

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