VNQ: A David Vs. Goliath Story

Summary

• Real estate ETFs are an excellent option for investors seeking low-cost, liquid, and diversified exposure to real estate. ETFs can complement or "anchor" an actively-managed strategy of selecting individual REITs.
• Our ETF Spotlight Series has taken us across the fund landscape from High Yield REIT ETFs and CEFs to newer innovative funds offering a more growth-oriented approach to real estate.
• The plain-vanilla "Core REIT" ETFs still rule the day, however, led by Goliath VNQ. We compare VNQ to five other ETFs that offer "cheap beta" exposure to commercial real estate.
• Due to the market-capitalization weighting system and the dynamics of the REIT sector, these ETFs tend to overweight the largest and relatively highest-valued and lowest-yielding REITs.
• With as much as 60% of weight in its Top-10 holdings, these ETFs may not offer the level of diversification that many investors assume. The property sector exposure also varies significantly between these funds.
• This idea was discussed in more depth with members of my private investing community, iREIT on Alpha. Get started today »

Real Estate ETF Spotlight

Real Estate ETFs are an excellent option for investors seeking low-cost, liquid, and diversified exposure to real estate. With nearly six dozen real estate ETFs to choose from, there's something for nearly every investor at every life stage and level of risk tolerance. ETFs can be used as the primary source of an investor's exposure to real estate or can complement or "anchor" an actively-managed strategy of selecting individual REITs. 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.

(Hoya Capital, Co-Produced with Brad Thomas through iREIT on Alpha)

"Core REIT" ETF Overview

Our ETF Spotlight Series has taken us across the fund landscape from High Yield REIT ETFs and Real Estate CEFs to newer, innovative funds offering a more growth-oriented or specialized approach to real estate investing. Recent innovation in the real estate ETF space has enabled investors to better customize their real estate portfolios toward their specific needs, objectives, and existing exposures, but the plain-vanilla "Core REIT" ETFs, which offer "cheap beta" exposure to commercial real estate, still rule the day from an AUM perspective. In this report, we focus in on the six most popular ETFs in the category.

"Core REIT" ETFs are distinguished by their market capitalization weighting system, exposure across most equity REIT property sectors, and ultra-low expense ratio - which averages roughly 20 basis points - a fraction of the typical actively-managed mutual fund or CEF. A theme that we'll discuss throughout this report, due to the market-capitalization weighting system and the inherent "top-heavy" dynamics of the REIT sector, these ETFs naturally overweight the largest "Goliath" REITs, which also tend to be the most expensive (based on FFO and AFFO multiples) and also the lowest-yielding.

Expensive and low-yielding may not be the worst qualities for a REIT portfolio, however. In our recent report, The REIT Paradox: Cheap REITs Stay Cheap, we discussed our study that showed that lower-yielding REITs in faster-growing property sectors with lower leverage profiles have historically produced better total returns, on average, than their higher-yielding counterparts. But while these ETFs may have some "factor tailwinds" at their backs, they also face some headwinds. Our study identified a mid-cap "sweet spot" of market capitalization that is associated with outperformance, suggesting that exclusively utilizing market capitalization-weighted indexes that are heavily overweight large- and mega-cap REITs may systematically underperform a more mid-cap heavy REIT portfolio over time.

One ETF stands alone in the "Core REIT" ETF category, and it's a true Goliath itself by any measure. Perhaps due to "career risk," a herding mentality, or simple unfamiliarity with the investment alternatives, many investors and financial advisors invest exclusively in a single ETF for their real estate exposure - the Vanguard Real Estate ETF (NYSEARCA:VNQ) - which itself commands nearly 60% of the total "Core REIT" ETF assets under management at nearly $40B.

VNQ is neither the cheapest, nor the most diverse, nor the most actively traded in the secondary market, but has nonetheless dominated the "Core REIT" category when it comes to AUM since launching back in 2004. In addition to VNQ, we also examine the Schwab U.S. REIT ETF (SCHH), iShares U.S. Real Estate ETF (IYR), Real Estate Select Sector SPDR Fund (XLRE), SPDR Dow Jones REIT ETF (RWR), and iShares Cohen & Steers REIT ETF (ICF). As discussed in A Banner Year for REIT ETFs, these "Core REIT" funds saw $5.3 billion in inflows in 2019, the best year for the sector since 2014.

What's The Difference Between VNQ And The Rest?

While many investors assume that these "Core REIT" ETFs offer nearly-identical and interchangeable exposure, there are indeed notable differences between these funds that investors should be cognizant of. Beginning with the similarities, as noted above, these ETFs are heavily skewed towards the upper end of the market cap range due to the "top-heavy" nature of the REIT sector, which naturally weights the portfolio towards more expensive and lower-yielding REITs.

Our equally-weighted Hoya Capital REIT 150 Index, essentially encompassing the entire universe of equity REITs, has an average AFFOx multiple of 16x and dividend yield of 4.80% compared to the "Core REIT" average of 23x and 3.0%, respectively, a function of the vastly different distribution of market capitalizations between the market-cap-weighted and equally-weighted design. Below, we chart the portfolio characteristics of these six ETFs.

Ironically, another potential drawback of the market capitalization weighting system in a top-heavy sector like REITs is that these ETFs may not offer the level of broad-based diversification that many investors assume. Led by XLRE and ICF with 60% of their total weight in just 10 holdings, these funds' performance is heavily impacted by just a handful of heavily-weighted names, many of which are in property sectors - such as cellular towers - that many investors don't typically associate with real estate.

Notably, the top-10 concentration varies from a low of 37% to a high of 60% and the number of holdings varies from 31 from ICF to 182 from VNQ. Even in IYR, the most "diversified" of the group, the position in cell tower REIT American Tower (AMT) is larger than the combined weight of 50 other names in the ETF and similar effects are seen in other funds with their large allocation to industrial REIT Prologis (PLD), mall REIT Simon Property (SPG), and cell tower REIT Crown Castle (CCI). Below, we show the top 10 names and relative concentrations of these six ETFs.

Property-Sector Breakdown of Core REIT 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. To the extent that investors are aiming to achieve truly representative exposure to commercial real estate at the national/economic level, the market capitalization weighting scheme - particularly when further constrained by a limited number of holdings - may be an ineffective or even counterproductive weighting system towards achieving that goal.

As REIT ownership levels vary widely from as low as 5% of total asset value in the single-family rental REIT sector to as high as 80% in the cell tower REIT sector, investors in these funds can be left with property-sector distributions that can be widely out of line with the underlying economic reality. Notably, XLRE has a whopping 24% exposure to cell tower REITs and another 10% to data center REITs, while having zero exposure to single-family rentals, a $4 trillion asset class. Notably, SCHH and RWR outright exclude cell tower and net lease REITs, while IYR is the lone ETF with mortgage REIT exposure. Below, we highlight the property sector breakdown of these six ETFs.

On that point, in our recent Decade in Review report, we charted the performance of each of the major REIT property sectors over the past decade. Four of the five best-performing real estate sectors over the decade were on the residential side as the positive tailwinds of the affordable housing shortage continue to provide a favorable macroeconomic backdrop for rental operators and homebuilders. The two worst-performing real estate sectors on the other hand were malls and shopping centers, as the so-called "retail apocalypse" continues to take its toll on landlords. Finally, the sector also saw three new property sectors emerge including two "technology REIT" sectors: cell tower and data center sectors, which have ridden the secular tailwinds related to "big data" and cloud computing and have each been top performers since bursting onto the scene around mid-decade.

Naturally, the historical performance of these ETFs largely reflects the relative performance of their respective sector over/underweights. On a one-year and three-year annualized total return basis, XLRE is the best-performing ETF in the category due to its heavy exposure to the top-performing cell tower and data center REIT sectors, while SCHH and RWR have woefully underperformed due primarily to their exclusion of these technology-based property sectors. Among ETFs that have been around for at least 15 years, VNQ is the winner, producing an average annualized total return of 8.7% during that time.

Our Conclusions: You Can Do Better Than VNQ

We've never been fans of the market capitalization weighting system - particularly in the real estate sector - a weighting scheme that we view as a somewhat archaic vestigial of a bygone era of high trading costs and before the advent of the "insanely efficient" ETF structure. We prefer weighing systems that better-reflect "economic reality" of a targeted macro-level exposure, rather than those easily swung around by company-specific events.

While these popular "Core REIT" funds offer cheap exposure to commercial real estate, we wonder whether investors are really getting the level of broad-based diversification that they assume, exemplified by the extraordinary 35% allocation to cell towers and data center REITs in a fund like XLRE while offering zero exposure to single-family rentals, a property sector many times its size. While this allocation has served it well over the last few years, a tech-specific correction in these highly-valued technology sectors, for instance, would leave many investors wondering how "passive" that ETF really was.

That said, there's no doubt that ETFs are an excellent and low-cost option for investors seeking diversified exposure, but using a single fund like VNQ - while still our top-pick in the "Core REIT" segment - discounts vast differences in investment characteristics within the real estate sector. We believe that utilizing a blend of several ETFs - and perhaps a selection of some individual REITs - may achieve a more acceptable level of diversification and optimize investment outcomes by allowing investors to tilt their real estate allocation towards their specific needs, objectives, and existing exposures.

Innovation in the real estate ETF marketplace over the past half-decade has enabled just that, better-allowing yield-oriented investors to be overweight the yield-oriented REIT sectors and underweight the more speculative, higher-growth sectors and vice versa. Similarly, renting households are able to efficiently allocate higher exposure to residential real estate to offset their significant liability to rising rents and housing-related costs, which is the largest annual expenditure for the average American household.

We emphasize again that investors evaluating ETFs, particularly funds that track more specialized or custom indexes, should focus primarily on the fund's holdings and underlying strategy rather than marginal differences in expense ratios, AUM levels, or measures secondary market liquidity like Average Daily Volume. We find that many investors "step over dollars to pick up dimes" by choosing only the ETF with the absolute lowest expense ratio, highest dividend yields, or highest AUM levels, overlooking ETFs that may offer more optimal long-term risk/reward profiles that generate superior total returns.

If you enjoyed this report, be sure to "Follow" our page to stay up to date on the latest developments in the housing and commercial real estate sectors. For an in-depth analysis of all real estate sectors, be sure to check out all of our quarterly reports: Apartments, Homebuilders, Student Housing, Single-Family Rentals, Manufactured Housing, Cell Towers, Healthcare, Industrial, Data Center, Malls, Net Lease, Shopping Centers, Hotels, Billboards, Office, Storage, Timber, and Real Estate Crowdfunding.

Disclosure: I am/we are long VNQ, SPG, AMT, PLD, EQIX, PSA, WELL, EQR, ESS. 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.