Real estate ETFs amassed impressive returns in the past few years. But this year has been different. Most funds are down in 2015 and underperforming the market. So what's in store for investors going forward?
"In recent years, it's been an ideal recovery for REITs .. . a perfect positive storm," said Morningstar analyst Robert Goldsborough. "You've had low rates, but you've also had a very slow and steady growth in the economy."
The largest REIT ETF, $46.98 billionVanguard REIT ETF (VNQ ), yields 4.1% and returned from 2% to 30% from 2009 to 2014. But it's down 7% so far this year. The lowest-costSchwab U.S. REIT ETF
( SCHH ) yields 2.41% and returned about 17%, 1% and 32% in each of the past three years, respectively. It's down 4% year to date. The S&P 500 is off 2%.
In prior years, incremental demand helped push occupancy as well as rental rates higher, driving up REITs' operating income, explains Goldsborough. Low rates also made the higher REIT yields more appealing to investors. As a result, real estate funds saw massive inflow of investor money.
But with the anticipation of rates going up, income investors started reallocating some of their investments elsewhere. "There's an investor sentiment of fear of interest rates going up. When rates go up, REITs have to allocate more to cash-to-debt servicing. That can be a problem for dividend payouts.... If you don't have massive economic growth alongside those interest-rate hikes, that constrains REITs as well," he said.
But many REITs are exposed favorably to an environment of rising rates, explained Todd Rosenbluth, director of ETF and mutual fund research at S&P Capital IQ. Within the real estate sector, he particularly likes retail and office space REITs.
Retail REITs are usually the largest or second-largest holding in many REIT ETFs and mutual funds. If the economy and retail sales are doing well, their prosperity translates into greater demand for retail spaces, driving occupancy and rental rates higher. This is good for mall property owners.
A similar situation applies to office space. "If the economy is doing well, people feel confident in their employment. If companies are hiring well, they need more office space," said Rosenbluth. Office REITs take up about 16% of SPDR Dow Jones REIT ETF ( RWR ) and 14% of Vanguard REIT ETF.
Todd Lukasik, Morningstar's senior REIT analyst, also likes health care facilities and outlet malls. While multifamily or self-storage places have traditionally been better investments amid rising rates due to their shorter leases, he finds those two sectors to be near their cyclical peak and thus overvalued.
The longer-term leases of health care REITs do provide some protection against rising rates: Their lease payments tend to rise at a rate of 2.5%-3.5% or the change in the consumer price index, whichever is greater, said Lukasik in a Morningstar interview. Big industry consolidation and an aging population should also drive demand for health care properties.
"There is a misconception that REITs underperform in rising-rate environments," said Adam Patti, CEO of IndexIQ, which offers theIQ U.S. Real Estate Small Cap ETF (ROOF ). "In fact, rising rates have historically been good for REITs across the board.... In the 16 periods since 1995 where interest rates rose significantly, REITs generated positive returns in 12."
The key to investing in real estate funds is diversification, Patti points out. "Unless you happen to be a REIT expert .. . you want to pick a diversified portfolio of different types of REITs."
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ, Inc.
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