Real estate investment trusts, or REITs, have come a long way from the drubbing they experienced this time last year.
The Fed-induced “taper tantrum” led to a significant sell-off in these income-generating vehicles that was primarily driven by rising interest rates and the fear of a slowing real estate market.
The majority of REIT ETFs fell between 15% and 20% in a two-month time frame, culminating in an excellent opportunity for value-seeking investors. Since that sell-off, we have seen a complete price retracement back to the prior highs as yield-hungry buyers have stepped back into the real estate game.
One of the attractive attributes of REITs is that they’re considered an alternative asset class with different risks and growth drivers than traditional stocks and bonds. This makes them an excellent opportunity to diversify your portfolio in an unconventional asset class, in addition to adding a much higher yield than the average dividend stock.
In fact, REITs are generally required to pay out the majority (at least 90%) of their taxable income as dividends to shareholders.
REIT ETFs – The 500-Pound Gorilla
In terms of size, the largest and most heavily traded ETF in this space is the Vanguard REIT ETF (VNQ). This fund is comprised of 137 publicly traded REITs with a total portfolio size of $42.9 billion. The top two holdings in the market-cap weighted VNQ are Simon Property Group (SPG) and Public Storage (PSA), and the fund is widely diversified in a number of hotel, healthcare, office, retail and residential REITs.
Probably the most attractive quality of VNQ over similar broad-based REIT ETFs such as the iShares Real Estate ETF (IYR) is its miniscule expense ratio. VNQ currently charges a tiny 0.1% management fee — or $1 for every $1,000 invested — compared to 0.46% for IYR. The only lower-cost vehicle in its class is the Schwab U.S. REIT ETF (SCHH), which touts an expense ratio of just 0.07% annually.
VNQ has an effective yield of 3.7% based on the most recent distribution, and income is paid quarterly to shareholders. So far this year, VNQ sports a total return of 17% as the combination of favorable real estate data and falling interest rates have been a tailwind for higher prices.
REITs are often very sensitive to changes in interest rates because their financing and acquisition costs are heavily reliant on a favorable yield environment. Investors typically shun REITs and REIT ETFs in a rising-rate environment because the additional risks you assume to own these companies versus other income opportunities become less attractive as bond yields rise.
Other REIT ETF Opportunities
While the majority of ETF assets in this space are focused on domestic REITs, a number of international and sector-specific offerings that are intriguing as well.
The SPDR Dow Jones International Real Estate ETF (RWX) is the largest fund by assets focused on overseas REIT holdings. RWX has more than $4.8 billion allocated to 136 foreign REITs, with the largest country allocations being Japan, United Kingdom and Australia. The dividend yield on RWX is listed at 4.43% as of the most recent distribution.
Another top international competitor is the Vanguard Global Ex-U.S. Real Estate ETF (VNQI). This ETF represents REITs in over 30 countries which include both developed and emerging market names. The VNQI portfolio is also much broader, with 551 holdings representing $1.4 billion in total assets.
International REITs can be an excellent way to diversify your exposure outside of the U.S. dollar and into burgeoning real estate opportunities abroad. However, both RWX and VNQI have lagged their domestic counterparts this year in total return. RWX has gained 8.98% and VNQI has increased 6.91% half way through 2014.
Blackrock also offers targeted regional international REIT exposure via the iShares Asia Developed Real Estate (IFAS) and iShares Europe Developed Real Estate (IFEU). Because real estate trends can develop in independent geographical areas, these funds allow you to hone in on more specific foreign countries according to your investment thesis.
If you want more targeted domestic REITs, the answer might lie in sector-specific offerings. There are several ETFs that are focused on industrial, residential, and retail companies that allow you to access opportunities in these niche areas. Each particular sector might perform better or worse than an aggregate index such as VNQ depending on the fundamental drivers for each theme.
For example, the iShares Residential Real Estate Capped ETF (REZ) is an ETF that invests in only residential, healthcare and public storage companies. It is currently sitting on a 2014 unrealized gain of nearly 20% that bests nearly every fund in its class.
The ETF universe has never been so inviting to income investors that are looking for diversified ways to enhance their portfolio yield. The plethora of options available allows you to hone in on the type and style of REIT ETF that meets your unique needs. In addition, many brokerage companies have several of these ETFs listed on their transaction-free schedules, which might help you decide which fund is most appropriate.
No matter how you slice it, REIT ETFs can offer uncorrelated returns with excellent yields during a surging real-estate or falling-interest-rate environment.
David Fabian is Managing Partner and Chief Operations Officer of FMD Capital Management. As of this writing, he was long VNQ. To get more investor insights from FMD Capital, visit their blog.