Why I Won't Buy REIT ETFs Or CEFs

Summary

• We think REITs deserve a place in every investor's portfolio.
• But how you decide to invest in REITs will have a major impact on your performance.
• We recommend investing in individual REITs if you have the time, skills, and interest, and favoring ETFs over CEFs if you prefer to follow a passive strategy.
• Looking for a portfolio of ideas like this one? Members of High Yield Landlord get exclusive access to our model portfolio. Learn More »

syahrir maulana/iStock via Getty Images

Today, 145 million Americans invest in REITs according to NAREIT. In other words, the majority of households hold some exposure to the REIT market and that's very understandable when you consider that:

• REITs have historically outperformed most other asset classes.
• REITs pay high yield in a yieldless world.
• REITs offer inflation protection in a money printing world.
• REITs provide diversification benefits in a volatile market.
• And finally, REITs remain underpriced in a bubbly market.

Therefore, it may seem like a no-brainer to invest at least a small portion of your portfolio in REITs. Even if you are not particularly bullish on them, it makes sense for the sake of diversification and inflation protection.

The more difficult question is how one should invest in REITs?

Here are three main options:

1. You could buy individual REITs.
2. You could buy a REIT ETF.
3. Or you could buy a REIT CEF.

While all three have unique pros and cons, I strongly believe that this is a sector in which you want to be selective and focus on individual REITs.

But if you lack the skills, time, and interest to make your own selection, then I would favor ETFs over CEFs, which in my mind are the worst option in most cases.

Below I explain 5 reasons why I won't buy REIT ETFs or CEFs and prefer to invest in individual REITs instead:

Reason #1: ETFs Aim to Provide "Average" Market Returns & CEFs Have Typically Done Worse Than That.

Research has shown that consistently beating the market averages is nearly impossible, and for this reason, investors should favor ETFs over active strategies.

This may be true for mainstream sectors such as large-cap (SPY) and tech stocks (QQQ), which are targeted by 1,000s of professional investors and efficiently priced, but it applies poorly to the REIT sector, which still presents frequent mispricings to this day.

In fact, similar research studies that specifically look at REITs have shown that active REIT investors have historically managed to beat market averages by a fairly large margin. This has also been my personal experience: (Source: Interactive Brokers. See disclosure at the end of this article)

My REIT portfolio has generated nearly 2x larger returns than the Vanguard Real Estate ETF (VNQ), all while enjoying much greater income. This was achieved by being more selective and investing in undervalued REITs.

So outperforming market averages is possible in the REIT sector.

Could CEFs capture this outperformance and save you from all the work? Unfortunately, not. Historically, most REIT CEFs, including the highly regarded Cohen & Steers Quality Income Realty Fund (RQI), have underperformed their passive benchmarks, despite taking a lot more risk through leverage:

	RQI	FTSE Nareit All Equity REITs Index
Since Inception (2/28/02)	9.93%	10.24%

Click to enlarge

That's likely because of the high fees that they charge, the use of too much leverage, closet indexing (more on that below), and other conflicts of interest.

Depending on the time period that you pick, RQI will come ahead of an ETF like VNQ because it is leveraged, but since inception, the risk-to-reward has been a lot worse. Even if you managed to get slightly better results thanks to the leverage, is it really worth it for the additional risk? I say no. RQI almost went broke in 2008-2009 and all it takes is one black swan for a leveraged vehicle to lose it all.

Reason #2: ETFs Invest Mostly in Expensive Mega-Cap REITs & CEFs Are Victim of Closet Indexing

Most REIT ETFs are market-cap weighted and as a result, they invest most of their capital into the largest REITs that exist. Because of that, there is a lot of artificial 'rule-based' demand for these REITs, causing them to trade at a lot higher valuations:

source

Today, investors get twice as much cash flow (and dividends) by investing in smaller and lesser-known REITs. Moreover, as these smaller REITs gain in size and get included in ETFs, they also enjoy multiple expansion, which leads to faster appreciation potential. In that sense, favoring smaller REITs has been key to our past outperformance.

Yet, REIT CEFs invest mostly in mega-cap REITs, just like ETFs, and if you look at RQI's top holdings, they are near identical to those of ETFs like VNQ. They both hold the same 5 REITs among their largest holdings:

• American Tower (AMT)
• Simon Property Group (SPG)
• Prologis (PLD)
• Public Storage (PSA)
• Equinix (EQIX)

Why is that?

There are two reasons for it.

First off, a CEF like RQI manages billions of capital, which limits where it can invest. A small-cap REIT may not have enough liquidity and therefore, they are limited to the larger REITs, just like ETFs.

But more importantly, CEFs are victims of "closet indexing", which is when active investors purposefully limit their deviations from ETFs in order to minimize any potential underperformance, which could hurt their business. History has shown that as long as the underperformance isn't substantial, investors are fine sticking with an actively managed fund, earning high fees to the manager, despite not providing materially different exposure.

Reason #3: ETFs and CEFs Invest Substantial Amounts Into Challenged Sectors.

It goes without saying that some property sectors are today deeply challenged.

Malls, hotels, and offices suffered a lot from the pandemic, but even beyond the pandemic, the future of these sectors is unclear.

"How much more pain will malls endure before the growth of Amazon (AMZN) starts to stabilize?"

"Will Airbnb (ABNB) continue to steal market share from Hotels?"

"Are employees as happy and productive working every day from the office, or are we moving towards a more hybrid work environment?"

We have our own opinions about these topics, but these are opinions at best, and different rational minds can have completely different expectations.

Yet, ETFs and CEFs commonly have a good bit of their capital invested in these challenged sectors. If you think that these assets will continue to gradually lose value over time, that's a big drag on performance, which could be avoided by building your own portfolio.

At High Yield Landlord, we think it is a mistake to completely avoid these sectors because they also present some interesting opportunities, but you need to be very selective.

Reason #4: Fees And Indirect Costs Add Up Over Time, Especially In the Case of CEFs.

The fees of ETFs are not significant but they compound over time. More important than the fees, there are substantial indirect costs in being market-cap weighted and having to regularly rebalance the portfolio.

In the case of CEFs, these costs have an even larger drag on the performance. A fund like RQI charges a 1.63% management fee, and on top of that, it needs to pay interest on its leverage, which leads to a 2.2% expense ratio.

You may think that the leverage is a good thing, but it really isn't. Over full-market cycles, the least leveraged REITs have done far better than the highly leveraged REITs because they suffered less pain during the down-cycle.

REITs are already leveraged, and CEFs add another layer of leverage on top of it, which leads to excessive leverage. This excessive leverage helps bolster an artificially high dividend yield in the immediate term, but it hurts total returns over full market cycles. To give you an example, RQI may have done great in the years leading up to the great financial crisis, but it then lost nearly 90% of its value in 2008.

Reason #5: Good ETFs and CEFs Don't Offer Enough Income.

Real estate is first and foremost an income-oriented investment. It also offers upside, inflation protection, and diversification, but the main reason for investing in real estate should be income.

With that in mind, ETFs fail to fulfill the main purpose of real estate as they don't offer enough income. ETFs like VNQ pay only 2-3%.

CEFs offer a lot more income than that, which may seem great on the surface, but in reality, this is just a trap to attract unsophisticated investors.

Here the yield is not generated by investing in undervalued REITs. It is generated mostly by using leverage, which we already discussed earlier.

At High Yield Landlord, we achieve an 8% cash flow yield, out of which 5% is paid to us in the form of dividends, and the remaining 3% is retained and reinvested by the REITs to grow the cash flow and dividend. We achieve this by investing in solid, undervalued REITs and using zero leverage.

Bottom Line:

If you want to be passive, then REIT ETFs are likely to provide better risk-to-reward than REIT CEFs in the long run. CEFs charge high fees, but don't provide materially different exposure due to closet indexing, and they try to make up for the high fees by using excessive leverage, which hurts them during down cycles.

But if you are prepared to put in some effort, then you could potentially do a lot better by being active and building your own portfolio of undervalued individual REITs.

This is the approach that I took and it paid off handsomely as my REIT portfolio generated ~20% average annual total returns over the past 5 years.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of SPG either through stock ownership, options, or other derivatives. 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.

Relevant disclosure to presented performance: past performance is no indication of future results. Our portfolio may not be perfectly comparable to the relevant index. It is more concentrated, includes international REITs, and may at times invest in companies that are not typically included in REIT indexes. The performance of our portfolio is underrepresented because it is affected by withholding taxes on all dividends. This is not the only account that I own, but it is the first account that I created for the sole purpose of building track record and it is now over 3 years old, which is probably just enough to assess results. The performance is money-weighted.

Comments

[theheckwithtech]

I agree 100% with the premise of your article however, there is one fund, managed by Hoya, a well known SA contributor, who has started a new REIT fund that has a unique and interesting approach in its holdings, and also pays monthly. The symbol is RIET and you might want to investigate this one a little further. I am accumulating at $15.50 or less.

[Miles13]

@theheckwithtech How are you accumulating at $15.50 or less?

[theheckwithtech]

@Miles13 ummmm....when it drops to $15.50 or lower, I buy more.

[Miles13]

@theheckwithtech That's my point, the price has not been down that low since it's inception.

[bbob68]

Thanks for sharing your perspective. I guess the exchange of ideas is a good thing and SA is certainly the marketplace for that. One very successful author takes one position and others, equally or more successful take another. There's obviously merit to both but in the end, it's up to the individual investor to suss out what seems to work and take your best shot. In my opinion, Buffet has it right: unless you have the time and talent just go with the S&P because over the long run that's a bet on America.

[Jussi Askola]

@bbob68 And to be clear, I agree with Buffett. Investing in the S&P makes a lot of sense to gain exposure to the broader stock market. Note however that we talk about REITs here - which is a different asset class.

[bbob68]

@Jussi Askola Yes,I understand that and believe you are likely a very successful investor/advisor. But the point Buffet made applied to all investments in securities--including REITs.My broader point was that the average investor is trying to deal with a plethora of financial advice, much of which contradictory. That is the issue buffet was addressing.
Personally, I am generally in your camp of having exposure to a number of sectors, including the S&P and REITS. But, what success I have had has come from a slightly different perspective from another author who favors the CEF universe, among which RQI is prominent.

[labman106]

I own all three categories: individual REITs, ETFs and CEFs. My main interest is how each category performs in small and large market crashes, i.e. max drawdowns and total recovery time. Individual REITs for me are all about total return where the lackluster dividend comes along for the ride. Here is where I must rely on expert advice. ETFs and CEFs, not so much.

[Jussi Askola]

@labman106 Thank you for sharing your thoughts. In case that could interest you, feel free to join us for a 2-week free trial to access all our Top Picks: seekingalpha.com/...

[craftbrewinfo]

@Jussi Askola What works for you is fine and does not work for everyone.

"Why I Won't Buy REIT ETFs Or CEFs" Simple for me.. I buy REITS AND CEF's..... Individual REITS for capital appreciate and growing dividend, and CEF's for yield and current income. That works for me.

[Jussi Askola]

@craftbrewinfo That does not make sense. You could also add margin on your individual REITs and you would get the same amount of income. That's essentially what CEFs are doing. The yield is achieved thanks to leverage.

[craftbrewinfo]

@Jussi Askola Yes , but with a small handful of exceptions ( O immediately comes to mind) CEF's pay monthly dividends... kind of hard to live on quarterly payouts,so it makes plenty of sense to me

[Dennis O]

@Jussi Askola I agree. That is one benefit of Cef's that I love. THAT is one reason to buy them . When you say an individual can do the same thing by adding margin or options that sir is why I leave that to the professionals who run the Cef's. I personally do not care about adding that to my already stock picking toolbox. The management teams that work with my 40+ Cef's do a much better job then I could. That still gives me plenty of opportunity to manage my 60+ individual stocks. If I was forced to go one direction or another I would side with Cef's. Grant you it would take some of my enjoyment out of the game. -Dennis

[bbob68]

"To give you an example, RQI may have done great in the years leading up to the great financial crisis, but it then lost nearly 90% of its value in 2008."
Were you invested in Reits during this time period and if so how did they do?

[Jussi Askola]

@bbob68 It was a real estate crisis. All real estate investments did poorly, including REITs. RQI did a lot worse than average due to the leverage. Individual REITs quickly recovered.

[Go4Gold26]

Jussi-I used to own a lot of CEFs and ETFs. Over time (~15 years), I saw I was doing better than all of them on my own, without the high costs. Now I have ETFs only in managed Roth accounts, which at least have the advantage of being low cost. So I agree totally that CEFs for REITs (and generally) are only for those who want exposure but don't want to manage these assets. And my experience bears out the research you reference--CEFs enrich (it appears) only those who runs them.

[Jussi Askola]

@Go4Gold26 Thank you for sharing your experience

[Dennis O]

I have 20 plus Reits and many have done real well but as long as I keep Reits in my portfolio I will nevery sell RQI/RNP. You could say the same thing about individual utility stocks which I also own several but I would never sell my UTF/UTG. You could say the same thing about drug companies but I will never sell THQ/HQH. My point is owning different sector CEF's is not any different then owning SPY OR QQQ which many own as a good hedge to markets.- Dennis

[Jussi Askola]

@Dennis O Yes, it is different. CEFs that are leveraged are different from ETFs and arguably a lot worse due to the high fees, conflicts of interest, and higher risk.

[Dennis O]

@Jussi Askola I have 40 plus Cef’s and the difference they make is NAV vs. market price and determining buying at a reasonable price plus it’s easy to see what direction the coverage of dividends are going by just checking the dividend by NAV coverage percentage. Plus the management team is probably most important which is easy enough to determine thru keeping advised by the many great Cef authors on SA. I feel there is room for all these different methods of growing wealth but I put the edge to Cef’s particularly if one is a dividend investor as I am.

[Jussi Askola]

@Dennis O I agree that they may make sense as trading vehicles around the Price/NAV. However, I would not consider them as good long term holdings in most cases.

[OutOfOffice]

Jussi -- good article and agree with my REIT portfolio mostly individual (WPC, MPW, AMT, ESS, STAG). However, I have 2 exceptions -- in retirement account where I cannot buy individuals (RQI instead) and a small holding of IGR at lower 2020 prices for some of the diversification outside US.

[Jussi Askola]

@OutOfOffice I would probably favor VNQ/VNQI instead of those CEFs. Thanks for sharing.

[jazznut]

I have no problem owning RQI, despite your valid arguments against it. Do wish I had pounced on STAG, however, when it was meandering in the low 30's.

[Jussi Askola]

@jazznut Especially today, I would not want to have leveraged exposure to rather expensive mega-cap REITs. In 2020, it was very different

[TheWallStreetKid]

Going against RQI as the author has is like being against a Sunny Day.

[Jussi Askola]

@TheWallStreetKid I am not against it. It may have its place for some high risk tolerant investors. However, I think that ETFs offer better risk to reward in most cases.

[albertciampi]

One of your better articles and plainly explained the benefits/drawbacks of each category. Personally I like the fact that CEF’s can use leverage vs ETF’s however in an overvalued market this can work against you. I own both VNQ & RQI and RQI. Has marginally outperformed although VNQ has a much lower management fee. The article on Amarda Hoffler yesterday was excellent and I picked up a few shares this morning.
Thank you.

[Sleepless in Seattle]

@albertciampi: I agree: a very sensible article. I got out of the REITs I held and bought RQI because I began to realize I just didn't know enough about the multitude of REITs. I suspect the author is quite correct though that someone more knowledgeable than I could do better.

[Jussi Askola]

@albertciampi I appreciate your interest. Feel free to join us for a 2-week free trial to access all our Top Picks: seekingalpha.com/...

Have a great day!

[Jussi Askola]

@Sleepless in Seattle I would have done the exact opposite, especially in today's richly valued market. You don't want leveraged exposure to expensive mega cap REITs.

[Income4ever aka Cyclenut]

The new RE ETF from Hoya Capital looks pretty intriguing being its a mix of 100 e and m reits
Ticker = RIET

Long O, WPC, EPR, VICI, ABR, BRMK, EFC and RQI in sector
Contemplating RIET

[Jussi Askola]

@Income4ever aka Cyclenut It is heavily invested in mREITs. I prefer to avoid those. Otherwise, there is a lot to like about it.

[whatsthis1do]

@Jussi Askola The little spare time I have is spent reading articles from you and Brad... Since I'm not smarter than the market I like and hold $RIET. If you think there is a better ETF that mixes risk, yield and small cap exposure please share.
Sincerely, exhausted ;)

[Kinney Orwell]

RQI total return is 11.70% since inception

[Robbadob]

@Kinney Orwell
It does better still if you can buy it at a significant discount to NAV. One can often get it at a 5% or greater discount, but not now. Its return looks especially good when compared with other reit CEFs, but regardless Jussi has, for as long as I have followed him at least, handily beat it.

[Jussi Askola]

@Kinney Orwell The data is directly from the website.

[Dennis O]

@Kinney Orwell You are only looking at the market price change only. I assume you plugged RQI into SA. That does not include all the dividends reinvestments. Go to the MOMENTUM column and you will see TOTAL RETURN. RQI in 5 yrs. 109.82% return and in 10 yrs provided 324.31 % return and MAX is 662% return. How crazy is that? I use to do the same thing all the time I did not realize most charts do no include the dividend price added to the market price. Also to my knowledge these prices for CEF's are total return and all fees were included which makes it even better. Life is Good- Dennis

[Wayne51]

There is another reason that I invest in individual REITs rather than someone else's idea of a good REIT investment: I get the dividend when it is paid. I don't have to wait until the end of the quarter for the ETF. If someone is holding something that belongs to me, waiting even one month for the payday is not ideal.

[Mister Jimmy]

@Wayne51 Understood, though RQI pays its dividend monthly.

[Jussi Askola]

@Wayne51 Thank you for sharing.

[Jussi Askola]

@Mister Jimmy Which adds additional expenses, which go out of your pocket. There is a reason why most REITs don't pay monthly.

[Reit Investor]

Thoughts on RIET?

[Jussi Askola]

@Reit Investor It holds a lot of mREITs so it depends on what you think of those.