Finding Room for Income With Vanguard REIT ETF

| About: Vanguard REIT (VNQ)

By Abby Woodham

REITs have been one of the strongest-performing investments over the past three years, beating the S&P 500 solidly. Vanguard REIT Index ETF (NYSEARCA:VNQ) is our favorite way for ETF investors to gain exposure to the broad income-generating real estate market. VNQ invests in a cap-weighted survey of United States equity REITs, allowing investors to access the movement of REITs across sector and capitalization in one cheap package. And cheap it is: VNQ charges a bargain 0.10% expense ratio, the lowest in its category. Because REIT funds have very similar returns pre-expenses, low cost is one of the most important factors for picking which to invest in. VNQ's low price has helped it outperform its competitors on a regular basis. It is by far the largest REIT ETF with over $14 billion in assets, and the second most liquid. Just as there is much to like about REITs, there is much to like about VNQ.

REITs are a hybrid asset class, offering bond-like yields and the possibility of capital appreciation. Investors starved for yield and hungry for dividends will find REIT ETFs particularly attractive. VNQ yields almost 2 percentage points more than the current paltry 1.6% offered by 10-year Treasuries. Historically, REITs were a great diversifier because of low correlation with equities, but today they offer few such benefits; REITs are best thought of as part of a diversified equity allocation. Unlike equities, however, income-generating real estate has some inflation-hedging qualities because property prices move in line with inflation and nonsticky rents can change as needed. Historically, an investment in VNQ has preserved purchasing power.

If you have the choice, REITs should be held in a tax-deferred account because most of their dividends are taxed as income and don't benefit from the low 15% qualified dividend rate. The unfavorable tax treatment arises from the REIT legal structure, which, in exchange for no taxation at the company level, obliges the firms to pass on the vast majority of their earnings (and taxes) to shareholders.

Fundamental View
Equity REITs generate income by managing properties and collecting rent. They are required to distribute at least 90% of their income to shareholders, which is where their desirable yield comes from. VNQ's current yield is slightly lower than its historical median.

Since 2007, REITs have taken advantage of low interest rates and refinanced their debts: by the beginning of this year, about 40% of REIT debt had been refinanced. Many have rock-solid balance sheets and enough cash flow to cover their liabilities with ease. These strong fundamentals have not gone unnoticed, and our equity analysts think REITs are trading at slight premiums. VNQ's price/fair value is currently 1.07, compared to 0.93 for the S&P 500. Premiums shouldn't scare off investors, however, as REITs have traditionally traded at premiums in the same range or even higher.

The biggest challenges facing REITs as a whole are the potential for rising interest rates and economic uncertainty. The current rates are great for REITs: they are able to grow cheaply, refinance debt at attractive rates, and draw investors looking for income. When interest rates rise, REITs will become less attractive to income investors--but more importantly, it will become more expensive for them to finance growth projects. Because REITs must pass the lion's share of income to investors, they depend heavily on capital markets. REITs with dividend growth potential will be better placed to remain competitive when interest rates rise. The largest REITs have the best prospects for growth and stability.

Once upon a time, REITs did not march in lock step with the stock market and therefore were excellent portfolio diversifiers. Some proponents of REITs still tout their diversification as a major benefit, but this view is outdated: the correlation between REITs and the market has been rising since the turn of the century. As is usually the case in market downturns, the 2008 recession hurt REITs along with all other asset classes, and major index NAREIT subsequently lost over 40% in 2008. However, the crash was not the cause of the rising correlation. The trend began over half a decade prior. The rolling three-year correlation of monthly returns between the NAREIT index and the S&P 500 sharply increased over the decade from its 1998-2001 low of close to 0 to nearly 0.90 today. The likely culprit was the rising importance of indexing and the inclusion of REITs in major indexes, such as the S&P 500 in 2001. It's no coincidence that correlation began rising in the same time period. Before indexing, REITs were strong value investments and traded at a discount. A 2011 study suggests that consumer sentiment was a component of REIT pricing inefficiencies. REIT to market correlation has been historically cyclical, but these modern changes represent an essential shift in the way the asset class is perceived and utilized. Investors still looking to REITs for hefty diversification benefits will likely be disappointed.

Portfolio Construction
VNQ tracks the MSCI US REIT Index, which tries to replicate the cap-weighted performance of the broad U.S. equity REIT market. It does not hold mortgage REITs. The securities are chosen with liquidity in mind, so that replicating funds like VNQ can hold the exact constituents of the index. The index is rebalanced quarterly. About half of the fund's holdings are large-cap, approximately 15% are small- and micro-cap, and the remainder is medium market capitalization.

This ETF's expense ratio is 0.10%, which is the lowest in the category and significantly lower than its larger competitors. VNQ is allowed to engage in securities lending with 100% of the net revenue returned to shareholders. Vanguard has worked hard to lower the price over time and has cut the expense ratio almost in half since its inception in 2004.

The market has many options for investing in REITs through ETFs, and most have very similar holdings. Our favorite is VNQ, but we also like a few others.

IShares Cohen & Steers Realty Majors (NYSEARCA:ICF) is a good option for investors willing to sacrifice liquidity, cost, and size to capture the performance of just the largest few U.S. equity REITs. The extra concentration comes at a cost, as its expense ratio is over 3 times VNQ's. If you're worried about interest rates rising soon, this ETF is worth a look.

IShares Dow Jones US Real Estate (NYSEARCA:IYR) is the second-largest REIT ETF. Its 0.47% expense ratio makes it the most expensive of the largest REIT ETFs, but with an average daily volume of over 8 million, it is also the most liquid of the group. IYR's top holdings are the same as the other broad sector ETFs, with a few notable exceptions: IYR is the only large REIT ETF that does not only include U.S. equity REITs. About 9% of the portfolio is mortgage REITs, and slightly less than 4% is non-REIT real estate holdings. Investors bullish on mortgages may want to examine IYR to determine if the coverage is worth the price.

SPDR Dow Jones REIT (NYSEARCA:RWR) tracks a subset of IYR's index, excluding mortgage/timber REITS and other types of holdings that are impacted by factors other than the value of real estate. Its expense ratio is 0.25%, which is low within the category but not terribly competitive.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.