Forget Rate Tantrums, Bet On REIT ETFs

Dependence of REITs on debt for their business makes investors skeptical about their performance in a rising rate environment. Also, the investment world treating them as bond substitutes for their high and consistent dividend-paying nature make them susceptible to rising rates. This is why their price performance tends to fluctuate when the Federal Reserve is optimistic about raising rates.

Though the benchmark interest rate was kept unchanged in the range of 1 to 1.25% in the Fed’s September meeting, the central bank sounded super-hawkish, announcing its plans of winding down the huge $4.5-trillion balance sheet of Treasury securities and mortgage-backed assets. This will begin with a decrease of up to $10 billion a month and reach $50 billion a month, starting in October 2018. Particularly, investors were surprised to find “the central bank’s intention to go ahead with another rate hikethis year and three more in 2018.”

Of course, higher rate affects the present value of future cash flows. Therefore, asset valuation, including bond coupons and stock dividends, experiences a decline. However, barring short-term hiccups, this special hybrid asset class has proven time and again that rate hikes do not necessarily impact its long-term returns.

Rather, in most cases, the REIT stocks have rallied and outperformed the broader market when the rate has eventually moved north. This is because, for REITs, a rise in rates also ushers in scope for increasing future cash flows.

In fact, per a S&P Global study, there have been six periods during which the 10-Year U.S. Treasury Bond yields increased substantially since the early 1970s. In half of those six periods, U.S. REITs outperformed the S&P 500, matched in another and missed in the remaining two. Further, U.S. REITs generated positive returns in four of those six periods. This implies that REITs actually gather more steam amid rising rates.

In fact, any decision by the Fed to increase rate mirrors growth in the domestic economy, rising inflation and the Fed’s confidence in the recovery. And when the economy expands, there is growth in jobs and consumer spending. This in turn drives the prospects of the real estate sector because growth in the economy translates into greater demand for real estate, higher occupancy levels and landlord’s greater power to ask for higher rents.

And why not? Everything is not possible virtually and one will eventually need “real space” for economic activities. Therefore, a REIT’s earnings, cash flow and dividend get a boost as rate increases amid economic growth.

REIT Returns Through August

The latest trend of returns for a number of REIT classes too suggests that the focus has now shifted to the fundamentals of the individual asset category to which the REITs cater to, rather than interest-rate movements.

In fact, amid macroeconomic uncertainty in the United States and the consequent sloth in trading activity, the REIT industry underperformed the broader market in the first eight months of 2017, as indicated by the FTSE/NAREIT All REITs Index’s total return of 7.4% compared with the S&P 500’s 11.9% gain.

Despite this, a number of REIT categories showed strength and posted stellar returns. Among these are infrastructure REITs that gained 34.1% through August this year, and data center REITs which returned 31.8%. Moreover, industrial REITs delivered returns of 19.3%, handily outpacing the broader market. However, retail REITs bore the brunt with the sector incurring negative returns of 11.4%.

Obviously, growth in cloud computing, Internet of Things and big data is not only helping tech companies, but is also driving demand for data center REITs. Moreover, the industrial asset category hogged attention for experiencing high demand, with the economy and job market displaying signs of recovery, ecommerce gaining strength and the manufacturing environment remaining healthy. However, shrinking mall traffic and store closures amid aggressive growth in online sales kept retail REITs on tenterhooks, clearly suggesting that demand-supply dynamics and the performance of tenants played a key role in shaping up REIT returns, rather than interest rate movements.

REITs’ Dividends Still Stand Tall

Also, the U.S. law requires REITs to distribute 90% of their annual taxable income in the form of dividends to shareholders. This unique feature made the industry stand out and gain a solid footing over the past 15-20 years.

In fact, dividends are by far the biggest enticement to invest in REIT stocks, and income-seeking investors still continue to prefer them. This is because, as of Aug 31, 2017, the dividend yield of the FTSE NAREIT All REITs Index was 4.1%, which handily outpaced the 2% dividend yield offered by the S&P 500.

Among the REIT market components, the FTSE NAREIT All Equity REIT Index enjoyed a dividend yield of 3.8% while the FTSE NAREIT Mortgage REITs Index had a dividend yield of 9.6%. Over long periods, REITs have outperformed the broader indexes with respect to dividend yields.

Robust Capital Access

Moreover, REITs have been proactive in the capital market in recent years. They have opportunistically used the low-rate environment to make their financials more flexible, which is encouraging down the line for their operational efficiencies.

Further, investors' faith in this sector and their willingness to pour money into it is increasing. The stock exchange-listed REITs collected $69.6 billion in capital offerings in 2016 and raised $62.8 billion of capital in the first eight months of 2017 — well ahead of the $52.3 billion generated in the comparable prior-year period.

Growing Importance of REIT industry

In addition, the growing importance of the REIT industry over the years is quite evident with the creation of the exclusive headline sector for real estate under the GICS last year. Indeed, the REIT market has continued to expand with the FTSE NAREIT All REITs Index, comprising 227 REITs, had a combined equity market capitalization of $1.126 trillion at the end of August 2017. This is ahead of 219 REITs and $972 billion in equity market capitalization at the end of April 2016.

Exploring the Sector Through ETFs

We believe that this is the right time to explore the sector through Exchange Traded Funds (ETFs), so as to reap the benefits in a less risky way. Considering the return prospects from dividend income and capital appreciation, we have tracked the following REIT ETFs that could be worth considering:

Vanguard REIT ETF (VNQ)

The fund, launched in 2004, seeks investment results by tracking the performance of the benchmark – MSCI US REIT Index – which is used to gauge real estate stocks. The fund consists of 158 stocks, which acquire office buildings, hotels and other real estate property. The top three holdings are Simon Property Group Inc. (NYSE:SPG), Equinix, Inc. (NASDAQ:EQIX) and Prologis, Inc. (PLD). It charges 12 basis points (bps) in fees. VNQ managed to attract around $34.1 billion in assets under management as of Sep 25, 2017.

iShares U.S. Real Estate ETF(IYR)

Launched in 2000, IYR follows the Dow Jones U.S. Real Estate Index that measures the performance of the real estate industry of the U.S. equity market. The fund comprises 124 stocks with the top holdings including American Tower Corporation (AMT), Simon Property Group Inc. and Crown Castle International Corp. (NYSE:CCI). The fund charges 43 bps in fees (as on Jun 30, 2017) and its 30-day SEC yield is 3.38% (as of Aug 31, 2017). As of Sep 25, 2017, it had around $4.6 billion in assets under management.

SPDR Dow Jones REIT (NYSE:RWR) ETF(RWR)

Functioning since 2001, RWR seeks investment results of the Dow Jones U.S. Select REIT Index. The fund consists of 105 stocks that have equity ownership and operate commercial real estates, with the top holdings being Simon Property Group Inc., Prologis, Inc. and Public Storage (NYSE:PSA). The fund charges 25 bps in fees while the 30-day SEC yield is 3.50% (as of Sep 22, 2017). Its assets under management were $2.8 billion as of Sep 25, 2017.

Schwab US REIT ETF(SCHH)

This fund debuted in 2011 and tracks the total return of the Dow Jones U.S. Select REIT Index. The fund consists of 126 stocks that own and operate commercial real estates. The top three holdings are Simon Property Group Inc., Prologis and Public Storage. It charges 7 bps in fees while the 30-day SEC yield is 3.42% (as of Sep 25, 2017). Further, SCHH had $3.7 billion in assets under management as of Sep 25, 2017.

First Trust S&P REIT Index Fund(FRI)

Launched in May 2007, FRI is an ETF that seeks investment results of the S&P United States REIT Index. The fund comprises 161 stocks with the top holdings being Simon Property Group Inc., Prologis and Public Storage. The fund charges 49 bps in fees and had a 30-day SEC yield (as of Aug 31, 2017) of 3.63%. FRI had about $212.9 million in assets under management as of Sep 25, 2017.

iShares Cohen & Steers REIT ETF(ICF)

Incepted in 2001, this fund follows the Cohen & Steers Realty Majors Index. The fund comprises 30 stocks with the top holdings being Simon Property Group Inc., Equinix, Inc. and Prologis. The fund charges 34 bps in fees (as of Jun 30, 2017), while the 30-day SEC yield is 3.04% (as of Aug 31, 2017). Its assets under management were $3.2 billion as of Sep 25, 2017.

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