by Charles Sizemore | June 25, 2013 10:53 am
It might seem like madness to suggest buying real estate investment trusts 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 could very well continue for a while, so 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 should build a watch list of your favorite names and average into them on any weakness.
But what about REIT funds?
Given the popularity of REITs, a plethora of exchange-traded funds 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, a REIT ETF may be a great option for a 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 …
|REIT ETF||Ticker||DIV. Yield||AUM||Expenses|
|SPDR Dow Jones REIT||RWR||2.84%||$2.13B||0.25%|
|iShares Cohen & Steers Realty Majors||ICF||2.86%||$2.87B||0.35%|
|iShares Dow Jones U.S. Real Estate||IYR||3.52%||$5.78B||0.47%|
What is immediately striking about this group is the pitifully low yields on iShares’ RWR and ICF. For an asset class that is ostensibly income-focused, that simply is not enough income to warrant serious consideration.
Each of these ETFs uses a slightly different index to track the sector, but their top 10 holdings are nearly identical. Simon Property Group (SPG) is the single-largest holding in all four ETFs, and HCP (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 have yields that are a little less than impressive for securities that were desgined 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 “dealmaking” 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 might 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. 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 (VNQ) and the iShares Dow Jones US Real Estate (IYR).
IYR has a slightly higher current yield (15 basis points), but 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.
So for broad large-cap REIT exposure in long-term accounts, go with Vanguard’s VNQ.
Now, a look at “specialty” REITs …
|REIT ETF||Ticker||Div. Yield||AUM||Expenses|
|PowerShares KBW Prm. Yield Equity REIT||KBWY||4.36%||$71.8M||0.35%|
|IQ US Real Estate Small Cap ETF||ROOF||4.48%||$39.4M||0.69%|
|iShares FTSE NAREIT Residential||REZ||2.96%||$309.8M||0.48%|
|iShares FTSE NAREIT Retail||RTL||2.95%||$20.8M||0.48%|
|iShares FTSE NAREIT Industrial/Office||FNIO||2.72%||$12.5M||0.48%|
As I mentioned in the previous section, cap-weighting tends to skew the large-cap REIT ETFs toward 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 often can find better pricing and higher yields. You have to do your homework and look at the underlying property portfolios for signs of overconcentration in certain markets or deteriorating tenant quality. But with that added bit of work comes the potential for a lifetime of higher dividend payments.
Of course, with an index fund like KBWY or ROOF, you can avoid the homework by just buying the entire basket. However, both KBWY and ROOF are small in terms of assets under management and have fairly thin trading volumes, so be careful when buying or selling, and use a limit order.
Also, ROOF might be somewhat poorly named, as it includes both mortgage REITs and traditional equity REITs. (For anyone needing a review, “equity REITs” hold properties, which are real assets. “Mortgage REITs” hold mortgages and mortgage derivatives, which are 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.
With the housing market recovering and with the “Echo Boomers” (aka Generation Y or the Millennials) mostly 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 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.
Finally, I should say a word about mREITs.
Mortgage REITs operate like “virtual banks,” borrowing cheaply for the short-term and using the proceeds to buy long-dated mortgages. The difference between the two is the “spread,” which varies based on the term structure of interest rates.
Rising bond yields have wrecked the book value of these 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, mREITs 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. But please note that mortgage REIT dividends are fair less consistent than equity REIT dividends.
Note: I left out many REIT ETFs either due to lack of assets under management and liquidity concerns or because, in my estimation, they added no noteworthy new exposure that wasn’t already covered by another ETF.
Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management. As of this writing, Sizemore Capital was long VNQ. Click here to receive his FREE 8-part investing series that will not only show you which sectors will soar but also which stocks will deliver the highest returns. The series starts November 5 and includes a FREE copy of his 2014 Macro Trend Profit Report.
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