Here's How To Choose The Right REIT ETF Now
Charles Sizemore | Jun 26, 2013 03:33AM ET
It may seem like madness to suggest buying REITs at a time when yields are soaring and anything associated with “income investing” is getting slammed. But with many popular REITs down 30% or more, now is precisely the time to start digging around for value.
This bond market selloff roiling all income-focused securities may very well continue for a while, and I don’t recommend trying to catch the proverbial falling knife by calling an exact bottom in REIT shares. But at the very least, you can build a watch list of your favorite names and average into them on any weakness. This has been my approach in my own income-focused portfolios.
But what about REIT ETFs?
Given the popularity of REITs, a plethora of ETFs have sprung up, each offering a slightly different approach to the asset class. While I prefer to cherry pick a portfolio of my favorite REITs, REIT ETFs may be a great option for smaller accounts or investors who prefer a “one stop shop” approach.
I’ll go through several familiar (and probably not so familiar) names today.
Let’s start with the biggest and most popular ETFs in the segment, which hold the largest-cap equity REITs. In this space, we have the Vanguard REIT ETF (VNQ), the SPDR Dow Jones REIT (RWR), the iShares Cohen & Steers Realty Majors (ICF) and the iShares Dow Jones US Real Estate ETF (IYR).
What is immediately striking about this group is the pitifully low yield on RWR and ICF. For an asset class that is ostensibly income-focused, that is simply not a high enough yield to warrant serious consideration.
Each of these ETFs uses a slightly different index to track the sector, but their top ten holdings are nearly identical. Simon Property Group (SPG) is the single largest holding in all four ETFs, and HCP Inc (HCP), Public Storage (PSA), Vornado (VNO), and Equity Residential (EQR) feature prominently as well.
While there is nothing “wrong” with these large-cap REITs, some of them have yields that are a little less than impressive for securities that were designed to be income vehicles. Simon Property Group, the largest holding in all four ETFs, yields only 2.9%.
Some of these REITs—and Vornado has been a high-profile case of this in recent years—have evolved away from pure landlording and have moved to become “deal making” growth vehicles in which property speculation is as important (or more so) than collecting rent checks. Again, there is nothing inherently “wrong” with this, but it may not be what you are looking for if you consider yourself an income investor.
Not surprisingly, since all four large-cap REIT funds hold substantially the same securities, they tend to track each other pretty closely (see Figure 1). Given that these are index investments with no active management in place, the smartest course of action is to buy the ETF with the highest yield and lowest management fee. This leaves us with the Vanguard REIT ETF and the iShares Dow Jones US Real Estate.
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The iShares Dow Jones US Real Estate has a slightly higher current yield (15 basis points) though its management fee is 37 basis points higher.
Normally, I would call that close enough to be a wash. But the Vanguard ETF is a purer play on actual property-owning equity REITs, whereas the iShares fund has exposure to mortgage REITs and to non-REIT development and holding companies such as Alexander and Baldwin (ALEX), which, among other things, produces sugar and coffee on Hawaiian plantations.
For broad large-cap REIT exposure, go with Vanguard’s VNQ. I would consider this appropriate for a long-term asset allocation, and—in the interests of full disclosure—that is exactly how I utilize it myself.
Specialty REITS
As I mentioned in the section above, cap-weighting tends to skew the large-cap REIT ETFs towards a handful of very large REITs that tend to have mediocre yields. This brings me to two small-to-mid-cap REIT ETFs: The PowerShares KBW Premium Yield Equity REIT (KBWY) and the IQ US Real Estate Small Cap ETF (ROOF).
There is a lot to like about the small-cap sector. Because the REITs are smaller and less followed by Wall Street, you can often find better pricing and higher yields. You have to do your homework and look at the underlying property portfolios for signs of over concentration in certain markets or deteriorating tenant quality. But with that added bit of work comes the potential for a lifetime of higher dividend payments. And of course, with an index fund like KBWY or ROOF, you can avoid the homework by just buying the entire basket.
Unfortunately, both KBWY and ROOF are small in terms of assets under management and have fairly thin trading volumes. So, you have to be careful when buying or selling and you should use a limit order.
And ROOF may be somewhat poorly named, as it includes both mortgage REITs and traditional equity REITs. (For anyone needing a review, “equity REITs” hold properties whereas “mortgage REITs” hold mortgages and mortgage derivatives. One is an investment in real assets; the other in paper.)
I like KBWY’s portfolio and consider it worth owning alongside the large-cap Vanguard REIT ETF. National Retail Properties (NNN) is a core holding in several income portfolios I run, and I consider Omega Healthcare Investors (OHI), Government Properties Income Trust (GOV), and Health Care REIT (HCN) to be solid income producers.
And what about sector REIT ETFs?
iShares has multiple offerings on this front, but none are exceptionally appealing. The iShares FTSE Industrial/Office REIT ETF (FNIO) has 32% of the portfolio in just two stocks—ProLogis (PLD) and Boston Properties (BXP). It also has a pitiful $12 million under management and trades only 3,000 shares per day. This ETF may not be in business a year from now.
Likewise, the iShares FTSE NAREIT Retail REIT ETF (RTL) is heavily weighted in just one stock—Simon Property Group, at 22% of the portfolio—and trades just 8,000 shares per day.
The iShares FTSE NAREIT Residential REIT ETF (REZ) is the only sector REIT ETF that has any volume to speak of, at 70,000 shares traded per day, but even this is too low a volume for a larger portfolio. This residential REIT ETF is also the best diversified of the lot, though I do not consider apartment REITs particularly attractive at current prices and yields.
With the housing market recovering and with the Echo Boomers (aka “Generation Y” or the “Millennials”) now, for the most part, moved out of their parents’ basements and into apartments of their own, the strong demand that has underpinned the sector is looking a little more tepid. This doesn’t mean that the sector is facing a pending crash, mind you. But I don’t see the growth going forward, and 2.9% is not a high enough yield to warrant holding based on income alone.
And finally, I should say a word about mortgage REITs. Mortgage REITs operate like “virtual banks,” borrowing cheaply short term and using the proceeds to buy long-dated mortgages. The difference between the two is the “spread,” which varied based on the term structure of interest rates.
Rising bond yields have wrecked the book value of the REITs’ mortgage holdings and have prompted investors to dump the securities en masse. But going forward, a steeper yield curve is actually good, as it increases the spread between the borrowing rate and the lending rate.
The question you have to ask yourself as a potential investor is this: Has the curve finished steepening, or do we have a ways to go?
If believe, as I do, that the hike in Treasury bond yields is a short-term blip and not a major regime shift, then mortgage REITs as a sector make sense. Many of the larger names—such as Annaly Capital Management (NLY) now sell for well below book value.
But I should be clear here: while equity REITs are solid “buy and hold” investments for investors who want exposure to real, income-producing assets, mortgage REITs most assuredly are not. They are closer to publically traded hedge funds and are nothing more than highly-leveraged paper-shuffling vehicles. Mortgage REITs should be viewed as a trade, not a long-term investment.
On the ETF front, there are two mortgage REIT funds of note: the Market Vectors Mortgage REIT ETF (MORT) and the iShares FTSE NAREIT Mortgage Plus Index ETF (REM), which currently yield 9.25% and 11.15%, respectively. Though please note that mortgage REIT dividends are fair less consistent than equity REIT dividends.
Note: There are plenty of REIT ETFs I left out of this write-up either due to lack of assets under management and liquidity concerns or due to the fact that, in my estimation, they added no noteworthy new exposure that wasn’t already covered by another ETF.
Disclosures: Sizemore Capital is long NNN and VNQ. This article first appeared on InvestorPlace .
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