IYR: Rates Are A Headwind For Real Estate
Summary
- IYR provides exposure to a diversified basket of U.S. REITs.
- The dividend yield is at a record low and the P/CF is high relative to the S&P 500, which makes IYR overvalued in my opinion.
- Rates in the U.S. are expected to rise going forward. The last time we had a tightening cycle, back in 2015-2019, coincided with a lackluster performance for IYR's shareholders.
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Investment Thesis
REITs often pay substantial dividends and have the potential for moderate long-term capital gains. As a result, they are frequently seen by investors as a safe source of revenue and an inflation hedge. REITs generally achieve their returns through the use of leverage, which makes them vulnerable to changes in interest rates. In a rising-rate environment such as we have nowadays, higher interest rates tend to decrease the value of properties and increase REIT borrowing costs. As a result, the benefits of investing in REITs are skewed to the downside in my opinion. In this article, I will review the iShares U.S. Real Estate ETF (NYSEARCA:IYR), which provides exposure to a diversified basket of U.S. REITs.
Strategy Details
The iShares U.S. Real Estate ETF tracks the investment results of the Dow Jones U.S. Real Estate Capped index. This fund provides exposure to U.S. real estate companies and REITs, which invest in real estate directly and trade like stocks. This ETF is generally used for diversification purposes, to seek income, or express a sector view.
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Portfolio Composition
The index places a high weight on Specialized REITs (representing around 37% of the index), followed by Residential REITs (accounting for 16% of the index) and Industrial REITs (representing around 13% of the fund). The largest three sectors have a combined allocation of approximately 66%. I personally like the fact that the allocation to highly cyclical properties (such as industrial, retail, and mortgage REITs) doesn't exceed 50% of the total assets. In terms of geographical allocation, IYR invests exclusively in the U.S.
iShares
31% of the portfolio is invested into large-cap blend issuers, characterized as large-sized companies where neither growth nor value characteristics predominate. Large-cap issuers are generally defined as companies with a market capitalization above $8 billion. The second-largest category is mid-cap blend equities. It is interesting to see that IYR allocates ~62% of the funds to mid and small-cap issuers which generally have a larger runway to compound than large-cap issuers. That said, these stocks generally have a higher beta, which makes them more volatile compared to the market. I think it is important to see if you are comfortable with a higher level of volatility before purchasing IYR.
Morningstar
The fund is currently invested in 86 different stocks. The top ten holdings account for 44% of the portfolio, with no single stock weighting more than 9%. The fund is concentrated in a few stocks which are likely to drive future returns. If you are looking for more diversification, the Global X SuperDividend REIT ETF (SRET) could be an interesting alternative, even if it also invests in countries outside North America.
iShares
Since we are dealing with equities, one important characteristic is the portfolio's valuation. According to data from iShares, the fund currently trades at an average price-to-book ratio of 3.1 and an average price-to-cash flow of ~20. A multiple of 20x free cash flow seems a bit high in my opinion for real estate, which is ultimately a cyclical asset. Moreover, if we compare it to a plain vanilla S&P 500 ETF which trades at 15x cash flow, I do not see any real advantage for owning IYR, apart from the slightly higher dividend yield.
Is This ETF Right for Me?
IYR has a distribution yield of ~2.2%. Given the low yield, I don't think the reward compensates shareholders enough for holding a long position in this ETF. Additionally, you should keep an eye on the dividend growth history, which clearly shows a negative trend since 2016. As a dividend investor, the last thing you want is your monthly dividend payment to start shrinking.
Seeking Alpha
If you focus on valuation by looking at the dividend yield, it is worth noting that IYR has only been more expensive once in its entire history. In other words, IYR's dividend yield was almost always higher than it is today. As a result, I would personally wait for an entry point where the yield gets attractive.
Refinitiv Eikon
I have compared below IYR's price performance against the performance of the SPDR DJ Wilshire Global Real Estate ETF (RWO) and the SPDR S&P 500 Trust ETF (SPY) over the last 5 years to assess which one was a better investment. Over that period, SPY clearly underperformed both real estate strategies. However, I think it is interesting to note that IYR did better than the global real estate strategy over that period. To put IYR's performance into perspective, a $100 investment 5 years ago into this ETF would now be worth ~$131.45. This represents a compound annual growth rate of 5.6% excluding dividends, which is an average absolute return.
Refinitiv Eikon
If we take a step back and look at the performance from a 10-year perspective, the results don't change much. SPY came on top once again, followed by IYR.
Refinitiv Eikon
At the moment, however, the biggest elephant in the room in my opinion is related to how well this ETF will perform in a rising interest rate environment. If we go back to the previous hiking cycle that started in 2015 and ended in 2019, it is worth noting that IYR generated a 10% return, excluding dividends, while volatility was pretty high. I believe the hiking cycle that started in 2022 will be more aggressive than what we experienced seven years ago, which makes me think that IYR will likely underperform the market once again.
Refinitiv Eikon
Key Takeaways
IYR provides exposure to a diversified basket of U.S. REITs. The fund currently has one of its lowest dividend yields since inception, which makes it overvalued in my opinion, especially when you take into account that dividend payments have been on a negative trend since 2016. If we look at the macro picture, rates in the U.S. are expected to rise going forward. The last time we had a tightening cycle back in 2015-2019 coincided with a lackluster performance for IYR's shareholders. Given the abovementioned reason, I think IYR doesn't offer an appealing risk-reward opportunity at the moment.
This article was written by
Analyst’s 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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