Over the weekend I read an entertaining article by Thomas Sobon, "What's Wrong With The REITs," in which he attempted to provide rationale for the recent sector sell off. Mr. Sobon's conclusion, which I strongly disagree with, is that three ETFs (VNQ, IYR & RWR) were the main culprits behind the dramatic price drop. In this article I will explain why ETF "selling" had little, if any, impact on underlying REIT equity pricing over the past several weeks. I will also provide an alternate thesis as to why the stocks sold off and why further selling may be in store for various sector constituents.
Understanding ETF Mechanics
Mr. Sobon's thesis was based on the view that increased volume in the aforementioned ETFs during the recent downswing necessarily meant that the funds themselves were selling their underlying holdings. This is an understandable, yet incorrect assumption. ETFs trade in an open environment on the stock exchange with a fluctuating level of outstanding shares, similar to an open-ended mutual fund. REIT ETF shares represent a basket of REIT stocks: VNQ is composed of 126 underlying REITs, IYR is composed of 95, and RWR, eighty-three.
An ETF, like an open-ended fund, usually only redeems securities when it experiences a net outflow of assets. If there is an equilibrium between buyers and sellers of the fund, regardless of what is happening to the underlying assets and the fund's NAV, the ETF won't be forced to buy or sell. While one might assume that fund flows are negative to an ETF during a sector sell off and decline in associated NAV, that does not have to be the case. It is possible for significant NAV to be lost, but for additional shares to be issued (creation units) because purchasers outnumber sellers of the ETF.
Thus, it is direct buy/sell activity as it pertains to the ETF (fund flows), and not the performance of the fund's underlying holdings, ETF volume or any other fundamental indicator, that typically determines whether an ETF is a de facto buyer or seller of securities in the open market.
Tracking REIT ETF Fund Flow
So to determine if there was in fact net selling pressure, we need to track net fund flows for the ETFs in question for the past several weeks. Utilizing the fund flow tracking tool on IndexUniverse.com, I came up with the following data:
Flows for VNQ IYR RWR 05/21/2013 - 06/28/2013
|Ticker||Name||Net Flows ($,mm)||Market Cap||Price Performance|
|RWR||SPDR Dow Jones REIT||76.82||~2.2 Billion||(-12.3%)|
|IYR||iShares Dow Jones U.S. Real Estate||-421.95||~4.7 Billion||(-12.6%)|
|VNQ||Vanguard REIT||-925.58||~19.2 Billion||(-12.9%)|
Two of three ETFs had outflow, while RWR actually experienced inflow (as I explained was possible) during this period. The net outflow between the three funds amounted to approximately $1.27 billion dollars, which would seem to support Mr. Sobon's contention to an unknown degree. However this amount is meaningless without analyzing it via a larger context. We need to consider the market caps of the ETFs in question and we also have to take into account the total market cap of the REIT universe before coming to any conclusions as to how meaningful the $1.27 billion outflow really is.
If we add the market caps of the three ETFs, we come up with $26.2 billion. And according to REIT.com, the total market capitalization of all 139 equity REITs at the end of last year was approximately $544 billion. Since REITs have retraced most of their gains from earlier in the year, I think that number is probably still accurate. Therefore, with some simple division we can conclude the following:
- RWR, IYR and VNQ make up roughly 5% of the total REIT market capitalization.
- The net outflow from these three REITs over the past five weeks amounts to about .2% (two tenths of one percent) of total REIT market capitalization.
- ETF money flow and transaction activity had little to no impact on the recent bearish move in equity REITs.
Re-opening The Case File
So if ETFs weren't the culprit in the recent selling, what was? As I've stated previously, I think this was a widespread valuation based correction, pure and simple. REITs such as Realty Income (O), which I've written on several times recently (I,II), were trading at nosebleed FFOs compared to their rather meager growth expectations. The selling pressure was far flung, ranging from momentum and institutional profit takers to 'nervous nellie' retail investors, triggered by the Fed's innuendo that QE would come to an end at some point.
Though I'm not bearish on most REIT businesses and am less concerned about a mildly increasing rate environment than most, the valuation hurdle is a difficult one for me to get over. When I look at the investment landscape I see stocks like ConocoPhillips (COP) trading at about 10X next year's EPS, growing upper single digits, and yielding 4.4%. I see Philip Morris International (PM) growing double digits, selling at a 14 multiple, and yielding almost 4 percent. Realty Income and many of its sector peers will likely grow operating output in the mid single digits, yet they sell for upper teens multiples, and pay out, in some cases, less in yield. It's tough to be "table-banging" bullish about a sector that doesn't, comparatively speaking, possess as robust a risk-adjusted growth story.
While I stated previously that a "fair" value for O probably rests in the $40-$44 level that it has recently traded at, this represents far from bargain basement pricing in my view. From a total return perspective I think one can do better elsewhere. Still, for investors looking for income and equity-income diversification, I wouldn't avoid the sector altogether. I just don't think I'd overweight it - in fact I'd probably consider under weighting it at this juncture. Mr. Sobon concluded his article by stating that REITs will soon outperform the market. I suspect some will, but I'm of the opinion that most won't as investors continue to play detective with sector valuation issues and weigh opportunities elsewhere.
Additional disclosure: Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.