Real Estate ETF Spotlight
Real estate ETFs are an excellent option for investors seeking low-cost, liquid, and diversified exposure to real estate. Unlike investment alternatives like direct real estate investments that require a substantial upfront investment and lack liquidity, or real estate crowdfunding platforms that are effectively "black boxes" of illiquid and high-fee portfolios, real estate ETFs offer investors relatively easy, liquid, and diversified access to the real estate asset class.
With nearly 50 real estate ETFs to choose from, there's something for nearly every investor at every life stage and level of risk tolerance. Not all real estate ETFs are created equal, however, and like any real estate investment, investors should take a "house tour" before they purchase. In our ETF Spotlight series, we take a look under the hood of some of the most popular real estate ETFs and highlight the strengths and idiosyncrasies of these funds.
High-Yield Real Estate ETF Overview
"Give me yield or give me death" has been the mantra for many investors in a world of perpetually low interest rates during the post-recession period. With long-term government bonds offering near-zero inflation-adjusted yield, investors have piled into alternative investments including real estate over the past decade to quench this insatiable thirst for income. With investors piling into both private and publicly-traded real estate equities over the last decade, valuations continue to make new record highs, but current income yields offered by these investments (as measured by cap rates at the private-level and dividend yields at the public-level) continue to trend lower. With the benchmark real estate index, the Vanguard Real Estate ETF (VNQ) now yielding less than 4%, investors have turned to a handful of higher-yielding real estate ETFs. In this report, we look at five high-yield favorites.
The 5 High-Yield Real Estate ETFs
On Wall Street, there's certainly no free lunch. To achieve higher yields, high-yield ETFs typically assemble a collection of misfits, outcasts, small-caps, and recent underachievers. Analyzing exactly how and where each of these ETFs derives the extra yield is critical information for investors seeking to understand how each of these ETFs fits into a broader asset portfolio.
The Invesco KBW Premium Yield Equity REIT ETF (KBWY) tracks a dividend yield-weighted index of small- and mid-cap equity REITs. The only pure-equity REIT ETF of the group, KBWY invests in a committee-selected basket of 29 mostly small-cap equity REITs which are fairly evenly spread across property types, but is relatively overweight on hotels, retail, healthcare, and prison REITs.
The IQ U.S. Real Estate Small-Cap ETF (ROOF) tracks a market-cap-weighted index of small-cap equity and mortgage REITs. While not necessarily intended to be a "yield-oriented" product, the high-yielding basket of 75 small and micro-cap names is distributed fairly evenly across property types with roughly 15% exposure to the mortgage REIT sector.
The Global X SuperDividend REIT ETF (SRET) tracks an equal-weighted index primarily composed of US mortgage REITs and non-US retail real estate operators. With an index universe that spans across the US and international developed markets, the basket is selected by choosing the 30 highest-yielding REITs subject to volatility constraints.
The iShares Mortgage REIT Real Estate (REM) tracks a market-cap-weighted index of residential and commercial mortgage REITs. More like a bank than a real estate company, mortgage REITs profit from the spread between interest earned on real estate-backed mortgage debt and their short-term borrowing costs and often employ significant leverage to achieve high-single-digit or low-double-digit dividend yields. Historical growth rates for mortgage REITs have been far below their equity REIT cousins.
The VanEck Vectors Mortgage REIT Income ETF (MORT) tracks a market-cap-weighted index of mortgage REITs. A very similar product compared to REM, MORT invests in 10 fewer names and is slightly less top-heavy. MORT has a slightly lower expense ratio, but still has fewer assets than the massive $1.3B in AUM held by REM. Both REM and MORT pay quarterly distributions.
Sector Breakdown of High-Yield Real Estate ETFs
Readers of our research know that we put heavy emphasis on property sector analysis, recognizing that sector allocations are the single largest determinant of relative real estate portfolio performance. Real estate property sectors have vastly different growth outlooks and risk/return profiles, particularly when you throw mortgage REITs into the mix. Differences in property sector distribution will far outweigh any other "factor-effect" such as small-cap vs. large-cap over any reasonable time frame, so we believe that any portfolio analysis must begin with a sector breakdown.
As noted above, it's debatable whether mortgage REIT ETF should even be included in a discussion of real estate ETFs. When the Global Industry Classification System (GICS) broke equity REITs into a separate industry sector in 2016, mortgage REITs stayed behind in the financial sector. We include mortgage REIT ETFs here primarily to highlight the use of mortgage REITs as a source of higher yield for ROOF and SRET. Again, as we mentioned above, the yield premium from these ETFs has to come from somewhere. In the context of a diversified real estate portfolio, we view mortgage REITs like "salt and sugar:" a little bit tastes great, but too much will kill you. Mortgage REITs make up about 6% of the NAREIT All REIT Index, and we think that a 5-10% allocation is probably a good benchmark allocation within a typical investor's real estate portfolio.
While mortgage REITs pay the juiciest dividend yields, as we point out below, they tend to experience limited or negative rates of dividend growth, particularly in a rising interest rate environment. Over the past three years, the broad-based equity REIT ETF, VNQ, saw a 4.2% CAGR rise in dividend payments per share compared to a 4.5% decline in REM.
Source of Yield for High-Yield Real Estate ETFs
Again, there is no free lunch on Wall Street, and understanding the source of the yield premium is critical to understanding where these ETFs fit into a broader portfolio. While the sources of yield for REM and MORT is readily apparent and known to most investors, the more interesting comparison is between the three other high-yield real estate ETFs. The sources of the yield premium on these ETFs can generally be categorized into three buckets:
- Company-Level: Portfolios tilted towards REITs that have corporate governance or tenant quality issues.
- Property Type: Portfolios tilted towards out-of-favor property sectors with lower-growth prospects.
- Use of Leverage (Mortgage REITs): Portfolios tilted towards REITs that use a higher degree of leverage - notably mortgage REITs.
SRET: SRET derives much of the 4% yield premium for the use of leverage by investing more than 60% of the portfolio in mortgage REITs. A point that seems to be overlooked by many investors based on the comments and analysis on Seeking Alpha and elsewhere, SRET is essentially a mortgage REIT ETF that happens to include a handful of international and domestic equity REITs. There's nothing inherently wrong with that, but we don't think a broad-based equity REIT ETF like VNQ is an appropriate comparison.
KBWY: KBWY is the lone pure equity REIT ETF of the group, so it must derive its 3% yield premium from somewhere besides mortgage REITs. KBWY uses a mix of company-level and property type tilts to achieve its nearly 7% yield. KBWY is overweight on some of the most out-of-favor sectors including retail and healthcare and its top holdings include a handful of REITs with significant corporate governance of tenant quality issues.
ROOF: Our favorite ETF of the group, ROOF, dabbles a bit into mortgage REITs as well, but we generally like the broad-based sector diversification of this ETF, which includes a fairly representative mix of industry groups not too far out of line from the broad-based index. The 13% allocation to mortgage REITs, along with the generally lower valuations and higher yields on small-cap REITs, is the source of the roughly 2.5% yield premium over VNQ.
Historical Performance of High-Yield Real Estate ETFs
Over the past five years, all five high-yield real estate ETFs have underperformed the more growth-oriented VNQ on a total return basis, but higher-yielding real estate ETFs have generally exhibited less volatility than their broad-based peers. This is not necessarily surprising or out of line considering the relative outperformance of growth-oriented investments over their value-oriented peers during this time. Over the last year, the ETFs with the higher concentration of equity REITs have been the outperformers, led by KBWY and ROOF.
Mortgage REIT ETFs have generally exhibited less volatility than their broad-based peers over most measurement periods, serving as a decent source of diversification within a total real estate portfolio. ROOF has exhibited volatility that is more or less in line with the broader REIT average, but KBWY has exhibited notably higher volatility, likely due to its portfolio composition that is tilted towards companies in troubled sectors and having idiosyncratic company-level issues.
Bottom Line: Understand the Source of Excess Yield
In a world of perpetually low interest rates, investors have piled into yield-oriented equities and real estate sectors to quench their vivacious appetite for yield. High-yield real estate ETFs are especially popular, which offer juicy dividend yields of 6-10% compared to their broad-based real estate ETF counterparts yielding below 4%.
On Wall Street, there's certainly no free lunch. To achieve higher yields, these ETFs typically assemble a collection of misfits, outcasts, small-caps, and recent underachievers. Of the five high-yield real estate ETFs we analyzed, our favorite is ROOF, which sources its excess yield by dabbling a bit into mortgage REITs, but invests in a relatively diversified portfolio of small-cap REITs with a distribution of property types that is not too far out of line from the benchmark REIT index. Although not as bad as KBWY, the underlying quality of REIT holdings is still not great, reflected in its relatively poor rate of dividend growth over the past five years.
Real estate ETFs are an excellent option for investors seeking low-cost, liquid, and diversified exposure to real estate, but it's important for investors to understand what's actually inside these funds. These high-yield real estate ETFs have generally exhibited less volatility than their broad-based peers, making them suitable for real estate investors seeking a reliable stream of immediate income, but have generally underperformed over longer time periods on a total return basis.
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Disclosure: I am/we are long VNQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: It is not possible to invest directly in an index. Index performance cited in this commentary does not reflect the performance of any fund or other account managed or serviced by Hoya Capital Real Estate. All commentary published by Hoya Capital Real Estate is available free of charge and is for informational purposes only and is not intended as investment advice. Data quoted represents past performance, which is no guarantee of future results. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy.
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