VNQ: Why REITs Continue To Struggle To Hedge Against Inflation

Summary

  • The Vanguard Real Estate ETF is one of the largest ETFs around.
  • The $43 billion giant is struggling to hedge investors against the raging inflation.
  • We look at why that is and why REITs will deliver modest returns from here.
  • Looking for option income ideas that focus on capital preservation? I offer this and much more at my exclusive investing ideas service, Conservative Income Portfolio. Learn More »

Financial management concept. Housing mortgage and risks

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The Vanguard Real Estate ETF (NYSEARCA:VNQ) seeks to provide a high level of income and moderate capital appreciation. It does this by tracking the performance of a benchmark index that measures the performance of publicly traded equity REITs and other real estate-related investments. This index is called the Real Estate Spliced Index and VNQ has done a great job of tracking it. Note that returns below are until April 30, 2022.

REITs Hedge Against Inflation

VNQ (Vanguard)

Yes, there is a lag at times, but you have to expect that with the fees that ETFs have to pay. Those same fees are absent in benchmark indices and hence you will almost always see a little lower return for passive ETFs. While the ETF has done well, recent performance has been shaky. Interestingly, that happened just as inflation ramped up.

Chart
Data by YCharts

Is VNQ a hedge against inflation or not? The short answer is no. The longer answer is below.

Valuation Matters For Hedging Inflation

We often see investors lumping all forms of assets as inflation hedges. This has extended from real estate to art, to precious metals and even cryptocurrencies. In 2021, we even heard that all stocks were a hedge against inflation. When we check the real-world performance, we find none of that to be true. To hedge against inflation, REITs have to have 2 major characteristics:

1) Their cash flows must increase with inflation

2) Their valuation must not compress with inflation

REITs tend to do very well on point 1) but often not so well on point 2).

Will VNQ Holdings Increase Their Cash Flow With Inflation?

Ignoring the investment in the VNQ mutual fund equivalent, the top 5 holdings include Prologis (PLD), American Tower Corporation (AMT), Crown Castle International Corporation (CCI), Equinix, Inc. (EQIX).

REITs Hedge Against Inflation

Vanguard

All of them have grown their cash flow and cash flow per share quite nicely over the past few years.

Chart
Data by YCharts

While those are impressive results, we think the biggest tailwind here was the extremely low cost of capital. Debt refinancings have been extremely accretive, so much so that it is impossible to not buy assets for a positive return. Another top 10 holding, Digital Realty Trust, Inc. (DLR) is a prime example of this. DLR's occupancy in 2015 was 94.3%.

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DLR Q1-2016 Presentation

It dropped to 87.1% in 2020 and then down to 84.8% in September 2021.

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DLR Q3-2021 Presentation

In Q1-2022 we are down to 83.3%! Despite this, cash flow per share has increased, thanks to financing European debt at less than 1% on average. Interest rate tailwinds are now in the rearview mirror. Cash flow per share will increase for these REITs but expect far more difficulties in doing so.

Will VNQ Holdings Suffer From Valuation Compression?

There are lots of different valuation models for REITs and to us, most suggest that we are in a period of extreme valuation compression. We will go over just one below as an example. REIT returns and valuation changes can be forecasted by changes in BAA bond yields (lowest IG rated). BAA bond yields are great competition for REITs and we can gauge as to how REITs will perform based on where those yields stand. As you can see below, those yields have been going vertical.

Chart
Data by YCharts

There is a very good model for predicting REIT forward returns based on the current BAA yields. We think that model should be used with some skepticism when yields are jumping so quickly, but nonetheless, a look is warranted.

It compares the spread between the REIT dividend yield (of the index) to BAA bond yields. In all cases, it is assumed that the BAA bond yields are higher (and they usually are) than the Equity REIT Index Yield. Maximum returns are seen when REIT yields are less than 0.6% lower than the BAA bond yields. So in our current setup, if REIT index yields were greater than 4.44% (5.04% minus 0.6%) we could look forward to some spectacular returns from REITs.

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NAREIT

Where are we actually at now? Equity REIT index yielded just 3.13% at the end of April, making the spread in the last column of negative 2.1%. This is because BAA bond yields were at 5.16% at the time. The drop in REIT prices this month has actually got the equity REIT index yield to 3.4% and we are now in the second column from the left. So our expected forward two year annual total returns are expected to be about 5% for REITs. So this REIT smash while surprising to some, is flowing straight from the BAA model. In fact, we had addressed this long back about what happens if interest rates rise very rapidly.

Verdict

Despite increasing cash flow, VNQ holdings suffered a severe and sudden valuation compression as BAA bond yields knocked the wind out of them. A good deal of the selloff in REITs is now in the rearview mirror. But forward returns will still be guided by how high corporate bond yields get. We don't believe the final high in BAA bond yields is behind us and hence, VNQ will struggle to hedge against inflation. Once valuation compression is done, we will see a better correlation with inflation.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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