I last covered the Vanguard Real Estate ETF (NYSEARCA:VNQ), a cheap, simple, strong REIT index ETF, seven months ago. Since then, economic conditions have markedly changed, and so I thought a quick update on the fund was in order. VNQ's real estate holdings could benefit from two of the strongest current economic trends: rising inflation, and the ongoing shift towards value stocks and old-economy industries. VNQ seems poised to outperform under current market conditions, and is a buy.
VNQ is a U.S. REIT index ETF. It is administered by Vanguard, the second-largest investment manager in the world, and the popularizers of the simple, low-cost index fund. Vanguard is almost always my top choice for index ETFs, as the company's structure, it is operated as a mutual company and owned by its customers, ensures low costs for investors. Vanguard index funds are almost always the best in the business, and VNQ is no exception.
VNQ itself tracks the MSCI US Investable Market Real Estate 25/50 Index, a broad-based index of U.S. REITs. It includes all relevant U.S. REITs meeting a basic set of liquidity, trading, size, industry focus, and corporate structure criteria. It is a market-cap weighted index, with caps meant to meet regulatory standards concerning diversification and concentration. It is a relatively simple index, and an appropriate benchmark for the U.S. REIT industry. In my opinion at least.
VNQ's underlying index is quite broad, which results in an incredibly well-diversified fund. VNQ invests in 168 different REITs, and has exposure to most relevant industry segments. Concentration is about average for an index fund, with VNQ's ten largest individual holdings accounting for just 35% of its value. I'm excluding VNQ's largest investment, the Vanguard Real Estate II Index Fund (VRTPX), from these calculations, as VRTPX tracks the same index as VNQ, and so does not materially affect the exposures of VNQ.
VNQ, being a market-cap weighted fund, focuses on the comparatively large commercial sector, with smaller allocations to other more specialized sectors. Residential REITs are 'only' 14.3% of the value of the fund, as most residential real estate is held by individual families, and so are not taken into consideration when calculating public industry market-caps. Residential REITs are likely to be a greater proportion of the fund's holdings moving forward, as institutional investors are investing quite heavily in the sector.
The fund's larger holdings are almost all large. diversified, blue-chip REITs like American Tower Corporation (AMT), Prologis (PLD), and Realty Income (O). These are comparatively safe, high-quality REITs, but also have comparatively low yields. VNQ, being an index fund, also includes riskier, more speculative holdings. These include those focusing on the anemic mall retail sector, like Simon Property Group (SPG), but in generally smaller quantities.
Index funds include a little bit of everything. As long as the core holdings are of reasonably good quality, as is the case for VNQ, diversification serves to decrease portfolio risk and volatility, ultimately benefiting investors. VNQ's underlying index, strategy, and holdings provide investors with more than sufficient, diversified exposure to U.S. REITs. As such, the fund is an appropriate investment for investors looking for broad U.S. REIT exposure.
In my opinion, REITs deserve inclusion in basically any investor's portfolio for two key reasons.
First, is the fact that the U.S. commercial real estate market is a large, growing, significant portion of the country's economy. It has an estimated dollar value of $16 trillion, and counting. Some exposure to such a large sector makes sense, and VNQ provides investors with exactly that.
Second, is the fact that U.S. commercial real estate has been the best-performing asset class for decades, vastly outpacing equities, U.S. or otherwise.
U.S. REITs have outperformed all relevant asset classes for decades, due to the dynamism of the country's economy and real estate market. Secular interest rate declines, as well as strict zoning, has been beneficial too.
Considering the above, some exposure to the U.S. commercial real estate market, including VNQ, seems ideal for most investors.
On a more negative note, REIT returns have mostly stagnated these past few years. Underperformance has mostly being due to the strong, unprecedented tech bull market of the past few years. REIT returns have been reasonably strong, but tech has been even stronger.
An important caveat to the above, is the fact that REITs have started to outperform again, and have been one of the best-performing sectors of the past year or so. Which brings me to my next point.
Current economic and market conditions are, well, messy and in flux, but broadly positive for the U.S. real estate sector, and hence VNQ.
The most important economic development post-pandemic is heightened global inflation. Prices are up across the globe, with U.S. consumer prices increasing 7.0% YoY this past December, a four-decade high. Improved economic fundamentals from the post-pandemic economic recovery, fiscal and monetary stimulus, and supply chain woes explain most price increases. Above-average inflation rates have persisted for months, and see no signs of abating. Profiting from rising inflation seems like a reasonable idea, and real estate investments, including REITs, do just that.
REITs invest in commercial real estate assets, which, almost by definition, see higher asset prices and rents when inflation is high. REITs and REIT investors benefit from these trends in pretty direct, obvious ways. Higher asset prices lead to higher REIT NAVs, which should lead to higher share prices and capital gains for REIT investors. Higher rents boost REIT cash-flows, ultimately boosting distributions and returns for shareholders. VNQ's 2.7% dividend yield is already quite a bit higher than average for an equity fund, and inflation could boost yields further.
Higher inflation should lead to strong capital gains and higher distributions for REIT investors, a solid combination. Importantly, this has been the case for previous periods of high U.S. inflation, with REITs posting positive returns and outperforming equities during most of these. Commodities and gold tend to perform even better than REITs when inflation is high, but REITs do reasonably fine.
REITs can also potentially benefit from the ongoing shift towards value stocks and old-economy industries. As mentioned previously, technology stocks and other high-growth industries have seen skyrocketing returns and share prices these past few years. Returns been mostly due to improved fundamentals, but only mostly. Bullish investor sentiment has also played a role, and has led to frothy, historically above-average valuations.
Investor sentiment is fickle. Investors have grown weary of tech valuations this past year, and have shifted to value stocks and old-economy industries instead. This has lead tech to underperform, while REITs and similar industries have outperformed. Said trend is likely to continue, in my opinion at least, as tech valuations remain quite frothy.
On a more negative note, REITs are likely to be hurt from higher interest rates, as most REITs fund their acquisitions / growth through the use of debt. These are almost certainly coming, with most market analysts and Federal Reserve officials expecting several interest rate hikes in the year. Although higher interest rates will almost certainly be a negative for VNQ and its shareholders, I think the broader economic situation remains positive. Interest rates tend to increase during inflationary periods, and VNQ has outperformed during previous inflationary periods. If the past is any indication, rising interest rates won't stop VNQ from posting positive returns, and outperforming equities moving forward.
VNQ is a simple, cheap, strong U.S. REIT index ETF, which could outperform as inflation remains elevated, and as investors shift towards cheaply valued old-economy industry sectors. The fund is a strong investment opportunity, and a buy.
This article was written by
Juan has previously worked as a fixed income trader, financial analyst, operations analyst, and economics professor in Canada and Colombia. He has hands-on experience analyzing, trading, and negotiating fixed-income securities, including bonds, money markets, and interbank trade financing, across markets and currencies. He focuses on dividend, bond, and income funds, with a strong focus on ETFs, and enjoys researching strategies for income investors to increase their returns while lowering risk.
I provide my work regularly to CEF/ETF Income Laboratory with articles that have an exclusivity period, this is noted in such articles. CEF/ETF Income Laboratory is a Marketplace Service provided by Stanford Chemist, right here on Seeking Alpha.
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.