SCHH: Bottom-Feeding With Real Estate

Summary

• The market as a whole performed poorly last year, this is well known. What is surprising is how much worse Real Estate did by comparison.
• SCHH was part of this drawdown. The reality is that rapidly rising rates can hurt the Real Estate sector, but its long-term relation with higher rates is actually mixed.
• This fund is an easy way for retail investors to invest in this space. While many investors likely own their own home, investing in REITs offers commercial exposure.
• I think the performance from both 2020 and 2022 were a bit of an anomaly and that Real Estate will remain a more stable sector going forward.
• This idea was discussed in more depth with members of my private investing community, CEF/ETF Income Laboratory. Learn More »

Ultima_Gaina

Main Thesis & Background

The purpose of this article is to evaluate the Schwab U.S. Dividend REIT ETF (NYSEARCA:SCHH) as an investment option at its current market price. This is a broad sector ETF, with a stated goal to track, "the total return of an index composed of U.S. real estate investment trusts classified as equities". It has been a while since I covered SCHH, but its performance since I last wrote about it has been less than impressive. This made my "hold" rating about as spot-on as it can get:

Fund Performance (Seeking Alpha)

With 2023 underway, I wanted to take another look at this fund to see if it was finally time to upgrade my rating. After review, I do see a "buy" case emerging. I think Real Estate as a whole is too beaten down, there is continued opportunity in areas like Office Space and hotels as people return to office and business travel resumes, and the headwind of rising interest rates is starting to run its course. I will discuss these factors and others in this review.

2022 Was A Rough Year

To start, let me clarify what I mean about "bottom-feeding". This isn't to say these companies within SCHH are the worst of Real Estate or are poor companies. What I am referring to is performance - this is a beaten-down sector in a disproportionate way.

For perspective, let us look at relative performance. All of us know that the S&P 500 dropped into bear market territory last year at multiple times and ended the year down big. But this is a Tech and Consumer heavy index. So while the "market" was down by that measure, it doesn't really capture everything. One area that is notably (mostly) absent from the S&P 500 Index is Real Estate, and that was a good thing last year for investors. The sector saw a drop of 25%, far outpacing the drop of the S&P 500:

2022 Performance (Real Estate vs S&P 500) (S&P Global)

This is not really a comforting metric. But it does offer up a potential opportunity in my eyes. This is clearly an unloved sector. Are there some legitimate reasons for that? Yes. But does this also give investors a contrarian opportunity to buy into a beaten-down arena. These are the types of plays that have potential for long-term "alpha". In the case of a generally stable sector like Real Estate, I think the risk is worth the reward at these levels.

SCHH Has Some Niche Exposure

The challenge with evaluating "Real Estate" is that it can mean a host of different things. Most Americans think of it as owning a home or renting an apartment. Investors may think of it as investing in commercial office properties or industrial centers. Or maybe it is hotels and malls, or something more niche. So - who is right? The answer is all of the above. When investing in a broad Real Estate fund like SCHH, a retail investor is getting exposure to a host of different plays. I view this as a good thing personally, but some readers may want their REIT to be specialized. The right strategy depends on the person, there is no right or wrong.

What I do like about SCHH is that it holds some of those niche sectors. Its top holdings offer investors REIT exposure to industrial and data center capacity, logistics facilities, self-storage, among other things:

SCHH's Top Holdings (Charles Schwab)

I see this as favorable because some of these REITs have counter-cyclical demand. Areas like self-storage can actually see higher demand when the economy sours. Others, such as data communications and logistics, could also hold up well as companies get leaner, more adaptive, and/or shift to e-commerce/business alternatives.

What I am getting at here is that if one is worried about an economic downturn (as I am), then perhaps Real Estate is not as risky as meets the eye. Many of these REITs could potentially hold up better than other cyclical or discretionary areas like tech, retail, or banking. This suggests there is a strong case to be made for adding a fund like SCHH for diversity and as a potential hedge.

Return To Office Has A Way To Go

Another potential tailwind for Real Estate, especially in the office and commercial spaces, is that the "return to office" trend is still a work in progress. Again, this is not "good" for Real Estate investors at the moment. As fewer workers utilize office space, the demand for said space remains depressed. This correspondingly limits the appreciation of the underlying values of the property these REITs own or rent. The remote work trend and recent job cut loss announcements are certainly part of the reason for Real Estate's drop last year and SCHH's underperformance.

This probably also sounds like bad news. But it reverts to the "opportunity" thesis. Things are bad right now for this sector. Rising interest rates, worries about the economy, a shift to remote work, and an acceleration of e-commerce trends are very real pressures. But the bright side of this story is share prices reflect this (a 25% drop in one year is no small feat!). So I would surmise the sector has brighter days ahead of it.

Look at the remote work trend as one example. The resistance of the return to office mantra of many companies has been a headwind for the sector. But we are starting to see more white-collar employees return to their urban and suburban workspaces in a consistent pattern across most major metro areas:

Office Occupancy Rates Since Start Of Pandemic (Kastle Systems)

What I see as support here is there is a lot of room for improvement - but that can be an investment opportunity. We can't wait until we are back to 80% or 90% occupancy rates to start investing. To be successful, retail traders need to front-run trends before they materialize and the opportunity is gone. I see improving metrics like this one - that also have a long way to go - as positive attributes because it leaves room for improvement. This supports my bullish take on Real Estate and SCHH by extension.

Apartment REITs Can Benefit From Higher Mortgage Rates

Rising interest rates were a drag on stocks of all stripes last year, with the exception of Energy. Although I would point out that Energy did not really benefit from rising rates per se, it rallied due to other factors. This could continue to be the case in 2023, so investors in U.S. equities need to manage this risk appropriately. SCHH could very well face continued pressure due to an elevated rate environment, so weigh this risk carefully in the first half of 2023.

However, higher rates can also work to the benefit of some REITs. Take REITs in the residential apartment space as an example. With mortgage rates rising and home prices remaining high, renting can begin to look more attractive by comparison (or some people are just priced out of buying all together!). While historically the better value has skewed towards buying in most areas of the country, rising rates have pushed the typical prospective homebuyer's monthly mortgage payment higher by roughly 60% in the past two years. This challenge opens up an opportunity for those who want landlord exposure in the apartment space because demand is going to continue to be there.

SCHH does hold some of this exposure, so I see it as a viable option. But readers can also look at a number of different REITs that are specific towards apartment rentals. One in particular I like is Mid-America Apartment Communities (MAA). This is a REIT I have owned for a long time, and I reiterated a bullish rating on it back in October. I bring this up because I see more gains ahead for this space and would encourage readers to consider it even if they decide SCHH is not the right product for them.

Professional Players See Value

A final point I would make on this sector is that there continues to be quite a bit of M&A activity. This should improve underlying values of these companies if they are able to realize synergies, cut costs, expand into new markets, etc. While these types of deals ground to a halt in 2020, M&A picked up sharply in 2021 and 2022, as shown below:

Real Estate Deals (S&P Global)

What I take away from this is that the big players are staying involved in this space, and in a meaningful way. I want to be a part of that, and SCHH is one simple way to get this exposure.

Bottom Line

SCHH has been having some trouble, but I see light at the end of the tunnel. I expect interest rates to rise modestly from here and then to level off and possibly begin to decline when 2024 gets underway. This stabilizing interest rate environment should bolster real estate investing and remain a long-term tailwind for the fund. Further, such beaten-down sectors often reverse, making now seem like an opportune time to at least get interested. I think the economic downturn ahead will not be as bad on this particular sector as it will be on others, so I view this as a more defensive play than others might. As a result, I am considering building a position in SCHH, and I encourage readers to give this idea some thought going forward.

Disclosure: I/we have a beneficial long position in the shares of MAA 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.