Executive Summary
- Long term total returns, diversification and income from dividends are the basis for the investment case in REITs.
- Regular distributions will make REIT ETFs less tax efficient than the typical ETFs for taxable accounts.
- Multiple ways to gain exposure with ETFs:
International – regional: IFEU, IFAS,IFNA
Speciality – large REITs: ICF, FTY
Specialty – property type: FIO, RTL,REZ, REM
Investment case
Investment Performance
REITs offer strong long-term total returns. During the period from January 1978 through June 2007, equity REIT performance exceeded both the broad equity market and other forms of real estate investment by more than 1 percentage point per year, producing an average annual return of nearly 15 percent.
As such, a $100 million investment in equity REITs at the beginning of that time period would have been worth more than $6 billion by the end.
Diversification
Modern portfolio theory holds that diversification is key to minimizing overall risk. In other words, investors should populate their portfolios with assets that yield returns with sufficiently different attributes from their other investments, i.e. create a portfolio of assets that behave differently across market conditions.
Doing so requires investors to seek out different types of assets with low correlation—a measure of the extent to which returns from different investments move together over time.
Analysts and portfolio managers tend to consider investments with correlations of approximately 60 percent or less to provide diversification. Since 1992, the correlation rate between equity REITs and the S&P 500 index has averaged about 35 percent, illustrating REITs’ strong diversification potential.
Dividends
REITs’ reliable income returns have been one of the chief drivers in the industry’s performance. In 2006, for example, REITs paid investors approximately $16 billion in dividends.
By law, U.S. REITs are required to pay out at least 90 percent of taxable income to their shareholders in the form of dividends. Most REITs, however, opt to pay out 100 percent or more. Consequently, REITs tend to generate a stable and consistent income stream for investors.
Data on average annual total returns from 1986 to 2007 illustrate the benefit of REITs’ steady income returns. While REIT stocks have exhibited clear potential for strong price appreciation, price returns can fluctuate from year to year.
In contrast, REITs have yielded a consistent annual income component of 7.6 percent during that period, representing almost two-thirds of the industry’s average annual total return of approximately 12 percent.
Liquidity
Investors long considered real estate to be the ultimate immovable, illiquid asset. Beginning in 1960 with the advent of REITs in the U.S., this age-old view has begun to change. REITs in the U.S. and many other parts of the world now make real estate investing easy and efficient, thanks to market liquidity.
The equities of companies that own portfolios of properties or engage in real estate financing are bought and sold on major U.S. stock exchanges. As the investor base for listed real estate has grown over the past decade, average daily dollar trading volume in the U.S. has soared – from about $100 million in 1994 to more than $3 billion today.
As a result of their liquidity, REIT and listed real estate equities have become the most efficient way for investors and investment managers across the globe to gain exposure to commercial real estate; an effective way for professional investment managers to manage their investment exposure to real estate; and a meaningful way to reduce the risk of illiquidity.
Inflation Hedge
Two factors make REITs an effective inflation hedge. The first is that REITs offset changes in the consumer price index with rent increases. Most property sectors, such as retail and office properties, are characterized by multi-year lease contracts in which rents are adjusted upward automatically to compensate for increases in the CPI.
Other sectors of the commercial real estate industry with shorter lease terms, such as multifamily housing, can implement rent increases to keep up with inflation as their shorter leases expire. Hotel REITs essentially can implement price increases on a daily basis.
REITs also provide inflation hedging benefits because, in times of increasing inflation, many investors move money into real assets, such as real estate. Because REITs are real estate in a securitized form, increased demand for REIT shares produces a nearly real-time increase in REIT share prices and shareholder value.
Source: NAREIT
Overview
Each of the top 3 ETF sponsors has at least one domestic REIT fund. International and specialty REIT ETFs are also available.
Domestic
Vanguard’s $2.3 billion REIT ETF(VNQ) tracks the Morgan Stanley Capital International (MSCI) US REIT Index. The index consists of 96 REITs spread across the retail, residential, office, industrial and specialized sectors. Top holdings include Simon Property Group, Inc. (NYSE: SPG), ProLogis (NYSE: PLD), Vornado Realty Trust (NYSE: VNO), Boston Properties (NYSE: BXP), and Public Storage (NYSE: PSA).
A twist on the Vanguard offering is that the ETF shares participate in the same $10 billion fund that Vanguard’s mutual fund investors own. The expense ratio for ETF shares is 0.10% compared to 0.20% for mutual fund investors who are also subject to a 1.00% early redemption fee.
iShares’ $1.9 billion Dow Jones U.S. Real Estate Index Fund (IYR) tracks the Dow Jones U.S. Real Estate Index which holds 77 REITs and is similar in composition to the Morgan Stanley Index. Top holdings include Simon Property Group, ProLogis, Vornado Realty Trust, Boston Properties and Equity Residential (NYSE: EQR). The expense ratio is 0.48%.
State Street’s $1.3 billion DJ Wilshire REIT ETF (RWR) tracks 87 REITs and is similar in composition to the iShare’s fund with the same top holdings. The expense ratio is 0.25%.
International
On the international side, State Street’s $970 million SPDR DJ Wilshire International Real Estate ETF (RWX) tracks 156 publicly traded real estate securities in countries excluding the U.S. Sectors covered include real estate operating companies, regional malls, office building owners and diversified real estate companies.
Top countries represented are Japan, Australia, U.K., Hong Kong and France. Top holdings include shopping mall titan Westfield Group (ADX: WDC), diversified Japanese developer Mitsui Fudosan (TSE: 8810) and Europe’s leading commercial developer Unibail-Rodamco (Paris: UL.PA).
The FTSE EPRA/NAREIT Global Real Estate ex-U.S. Index Fund(IFGL) owns companies engaged in the ownership, disposure, and development of the Canadian, European, and Asian real estate markets.
Regional versions of the same fund are also availlable in with FTSE EPRA/NAREIT Europe Index Fund(IFEU), FTSE EPRA/NAREIT Asia Index Fund (IFAS) and FTSE EPRA/NAREIT North America Index Fund (IFNA).
Specialty
The $2.6 billion Cohen & Steers Realty Majors ETF (ICF) owns relatively large and liquid REITs that may benefit from future consolidation and securitization of the U.S. real estate industry. The fund’s REIT holdings are diversified across property sectors that represent the current market.
The FTSE NAREIT Real Estate 50 Index Fund (FTY) owns the 50 largest REIT companies within the FTSE NAREIT Composite Index.
Investment by property type is available throught FTSE NAREIT Industrial/Office Index Fund(FIO), FTSE NAREIT Retail Index Fund (RTL) and FTSE NAREIT Residential Index Fund (REZ). In addition, the FTSE NAREIT Mortgage REITs Index Fund(REM) measures the performance of the residential and commercial mortgage real estate sector of the U.S. equity market.
One watch-out, REIT ETFs don’t necessarily have the same tax efficiency benefit as other ETFs. The reason is that the underlying REITs pay out capital gains distributions which then must flow through to the ETF investor. For that reason, check into when the capital gains get distributed and check with your tax advisor before investing.
In sum, the domestic REIT ETFs are remarkably similar in composition and performance, so the expense ratio should be the deciding factor and Vanguard is the leader for now.
Top Performers
Largest
1. FTSE NAREIT Industrial/Office Index Fund (FIO) – $3,995 million
2. Cohen & Steers Realty Majors (ICF) – $2,555 miillion
Lowest Cost
1. Vanguard REIT ETF (VNQ) – 0.10%
2. DJ Wilshire REIT ETF (RWR) – 0.25%
See the directory.