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By Abby Woodham

REITs have traditionally been viewed as a liquid way to buy commercial real estate and improve a portfolio's diversification, but the sector's investor base has expanded in recent years to include income- and growth-seekers. Vanguard REIT Index ETF (NYSEARCA:VNQ) is a well-constructed and cheap way to gain access to the REIT space. Vanguard often offers the same fund in mutual fund and ETF share classes, and this fund's mutual fund share class, Vanguard REIT Index (VGSIX), receives a Morningstar Analyst Rating of Gold.

Because most REIT ETFs have very similar holdings, expense ratios are a particularly important consideration when choosing a fund tracking the sector. Vanguard REIT Index's 0.10% expense ratio makes it one of the cheapest options available. It has also tracked its benchmark very closely: VNQ's estimated holding cost, which is a Morningstar data point that measures the difference in performance between a fund and its benchmark, is 0.03%. When a fund's estimated holding cost is very close to its expense ratio, it helps show that the fund is tracking well.

Another one of VNQ's attractive attributes is its inclusion of mid- and small-cap stocks. The fund's portfolio includes more than 120 holdings, which represent almost all of the real estate sector's total market capitalization. About 40 of those names are smaller stocks that are excluded from other REIT indexes. These smaller firms make up a relatively minor component of VNQ's portfolio but help diversify the fund.

VNQ yields 2.72% today, which is a full percentage point higher than the S&P 500. The spread in yield between VNQ and the S&P 500 widened last year, due entirely to the REIT sector's weak price performance in 2013 as the market processed its fear of rising interest rates. With REITs back on track in 2014, the spread has stabilized at about 100 basis points, close to the five-year average. REITs usually yield more than the broad equity market because of their legal structure: To qualify as a REIT, a real estate firm must pay out 90% of its taxable income to shareholders as dividends. This income is exempt from corporate-level taxation and passes directly to investors. In the years following the financial crisis, this high level of income has become popular with income investors dissatisfied with the low rates on fixed income.

Although REITs offer relatively attractive yields, they are still equities and are not a suitable alternative to low-risk investments such as Treasuries. Over the past three years, REITs were about 30% more volatile than the S&P 500 Index and 6 times more volatile than the aggregate U.S. bond market. Potential near-term risks include slower-than-projected growth, setbacks in the U.S. economy, and rising interest rates. The fear of rising rates proved to be a significant headwind to the sector in 2013.

Interest-Rate Worries
Rising interest rates are still the REIT sector's greatest potential headwind. Because REITs must pay out most of their income as dividends, they rely on debt for growth. For REITs, higher rates mean more-expensive debt servicing and less business reinvestment. REIT yields also become less attractive relative to Treasuries when rates are high, putting downward pressure on the sector's valuation. REITs that specialize in long-term leasing structures are particularly at risk. In May 2013, when the Fed announced that it would consider tapering, REIT prices slid for the first time in years and remained flat for the remainder of the year. According to Morningstar's senior REIT analyst, Todd Lukasik, "Although rising interest rates might signal a strengthening economy, which could benefit real estate fundamentals, we do not expect the macro environment to improve enough to offset what could be another 125-basis-point (or more) rise in rates to levels nearer historical norms."

However, concerns about REIT performance during a rising interest-rate environment may be overblown. Although investors panicked in 2013, REITs have recovered in 2014, with VNQ returning 16.4% year-to-date compared with the S&P 500's 5.0% return. Once investors acclimated to the shock of the Fed's potentially winding down quantitative easing, the market for REITs returned. Historically, the case has been much the same. Rates usually rise because the economy is strong, and REITs are cyclical businesses: An economic boom means higher occupancy and the ability to impose steadily increasing rates on tenants. Historically, REITs have shared in the growth of the broad U.S. market during bull markets. From 1994 to the end of September 2013, during rising interest-rate periods, REITs (as represented by the Dow Jones U.S. Select REIT Index) posted average six-month returns of 9.98% compared with the S&P 500's 11.42%. Past evidence suggests that economic growth is more important to REIT performance than interest-rate changes. Investors who are interested in learning more about REIT performance in different rate environments may be interested in this article from December 2013.

Putting aside interest-rate concerns, the fundamentals of the sector remain in good shape. The current economic environment is ideal for REITs, whose business model depends on the ability to increase occupancy rates and impose steadily increasing rents on tenants. The U.S. economy is expanding enough to grow demand for real estate incrementally but not fast enough to encourage real estate developers to build new properties. As a result, REITs are experiencing steadily increasing demand for rental properties without the downward pressure of extra property supply entering the market.

REITs are traditionally thought of as good diversifiers, but the correlation between REITs and the market has been rising since the turn of the century. There are two likely culprits: the crash of 2008 and ETFs like VNQ. During a market downturn, correlations rise between asset classes across the board. REITs were no exception. However, over the past decade there have been structural changes to the way REITs are viewed. REITs were once a relatively inefficiently traded sector, ignored by retail investors, but they have become a mainstream investment since the inclusion of REITs in major indexes, such as the S&P 500 in 2001. REITs are now more widely available than ever thanks to ETFs like VNQ. These recent changes may prevent REITs' correlation with the market from returning to historical low levels.

Portfolio Construction
VNQ tracks the MSCI US REIT Index, which includes all domestic REITs from the MSCI US Investable Market 2500 Index, which imposes minimum liquidity and size requirements. Constituents are weighted by their free-float-adjusted market cap. Mortgage REITs and non-real-estate specialty REITs (timber, prisons) are excluded. The index is reviewed semiannually and rebalanced quarterly. The fund's portfolio is diversified across property sectors. Retail REITs are the largest holding, at 27%. Office, residential, and health-care REITs take up about 15% each. Industrial (12%), hotel (7%), and diversified (9%) REITs are also represented. VNQ's sector holdings are not meaningfully different from its category average. Prior to May 2009, the fund tracked an adjusted version of the index that included a 2% cash position. Since then, cash accounts for less than 1% of the fund's assets.

When possible, REITs should generally be held in a tax-deferred account. Most of their distributions are taxed as ordinary income and don't benefit from the low 15% qualified dividend rate.

Alternatives
Only Schwab US REIT ETF (NYSEARCA:SCHH) can challenge VNQ's low price. It charges just 0.07% for a very similar portfolio. SCHH excludes the smaller REITs present in VNQ's portfolio, but 90% of their holdings overlap. We prefer VNQ's broader selection of REITs, but SCHH is an excellent alternative.

iShares US Real Estate (NYSEARCA:IYR) is the only large REIT ETF to include all REITs. Most indexes exclude REITs that derive the majority of their income from non-real-estate activities, a category that contains mortgage, prison, and timber REITs. IYR includes these REITs, which make up about 20% of its holdings. These firms are exposed to economic factors other than the real estate market. IYR is expensive at 0.46% a year. With inexpensive alternatives to choose from, this fee is difficult to justify.

Investors who want to buy only the largest REITs might consider iShares Cohen & Steers REIT (NYSEARCA:ICF), which tracks the 30 largest REITs. It costs 0.35% a year.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: This REIT ETF Remains The Prettiest On The Block