Real Estate ETF and CEF Spotlight
Exchange-Traded Funds (“ETFs”) are an excellent option for investors seeking low-cost, liquid, and diversified exposure to real estate. Closed-End Funds (“CEFs”), a fund structure that shares some similarities but also some critical differences from ETFs, can also make sense for certain investors who are seeking high income, access to leverage, active management, and are willing to pay a steep expense premium for it. In our ETF Spotlight series, we take a look under the hood of some of the most popular real estate ETFs and highlight the strengths and idiosyncrasies of these funds.
(Hoya Capital Real Estate, Co-Produced with Brad Thomas)
High-Yield Real Estate ETF and CEF Overview
“Give me yield or give me death” has been the mantra for many investors in the world of perpetually low interest rates throughout the post-recession period. With long-term government bonds offering near-zero nominal yield and below-zero inflation-adjusted yield, investors have piled into alternative investments, including real estate, over the past decade to quench this insatiable thirst for income. While just one small slice of this global search for yield, we note that more than $5 billion has poured into the 11 “core” US real estate ETFs last year alone, the best year for inflows since 2016, bringing the total haul into these 11 real estate ETFs alone to more than $20 billion.
With the benchmark “core” real estate index funds like the iShares US Real Estate ETF (IYR) now yielding less than 4%, investors have turned to a handful of higher-yielding real estate ETFs and CEFs to meet their income targets. On Wall Street, however, there’s no free lunch, and high-yield ETFs and CEFs have been hit disproportionally hard by the pandemic and, on average, remain lower by roughly twice as much as their broad-based “core” real estate ETF counterparts like the Vanguard Real Estate ETF (VNQ) and Schwab U.S. REIT ETF (SCHH), which are lower by roughly 16% this year.
Land of the misfit toys? High-yield REIT ETFs and CEFs typically include a collection of misfits, outcasts, small-caps, and recent underachievers, while CEFs take on an added dimension by utilizing leverage. When times are good, these misfits can produce outside returns to the upside, but when times get tough, watch out below. To that point, among the twelve worst-performing real estate ETFs of 2020, we find six of the seven high-yield real estate ETFs as well as six of the nine high-yield CEFs that we discuss in this report.
Yield Chasing Can Be A Dangerous Game
In our recent report, “The REIT Paradox: Cheap REITs Stay Cheap“, we discussed our study that selecting REITs based primarily on dividend yield has likely been an underperforming strategy over the past decade. Our analysis instead showed that lower-yielding REITs in faster-growing property sectors with lower leverage profiles have historically produced better total returns, on average, than their higher-yielding counterparts. While higher-yielding “diamonds in the rough” certainly do exist, the evidence suggests that systematically overweighting these highly-levered and “inexpensive” names may be a losing strategy over the long term.
That said, some individual and institutional investors simply need the immediate dividend income to “balance their budgets”, and will find that 5-10% yield one way or another. We stress that diversification is especially critical when “yield-chasing” to minimize elevated idiosyncratic risks, making real estate ETFs an efficient and low-cost option that offers instant diversification, while CEFs can make sense for certain investors who are seeking active management and are willing to pay a steep expense premium for it. Below, we outline the primary differences between these three fund structures.
Dividends Are Not Guaranteed
As we’ll expand on throughout this report, these higher-yielding real estate funds have been hit disproportionally hard by the wave of REIT dividend cuts, which has been the prevailing theme within the real estate sector since the start of the pandemic. 64 of 170 equity REITs have reduced or outright suspended their common share dividend this year, while 25 equity REITs have raised dividends in 2020 to levels above those of 2019.
The pain was actually more acute on the Mortgage REIT side of the sector. The magnitude of the cuts in the mREIT sector amid the pandemic was unprecedented, with 31 out of 42 mortgage REITs cutting or reducing their dividend between March and June. 22 out of 23 residential mREITs reduced or suspended their dividend, while 9 out of 19 commercial mREITs reduced or suspended dividends. Since the end of June, however, no additional mREITs cut or suspended their dividends and one mREIT increased its dividend above pre-pandemic levels.
While these dividend cuts “only” affected roughly one-third of all equity REITs, several of the ETFs and CEFs that we’ll mention experienced dividend cuts to 75% or more of their holdings. So, while the trailing-twelve-month dividend yields may still look “juicy” for many of these funds, we point out that these quoted yields likely overstates the expected forward yield an investor could achieve over the next year by anywhere between 100 and 500 basis points, depending on how soon these many of these REITs reinstate their dividend.
Understand The Source of The Yield
Again, there is no free lunch on Wall Street, and understanding the source of the yield premium is critical to understanding where these ETFs and CEFs fit into a broader portfolio and can help to minimize the chance of “swimming upstream” against the outperforming factors. The sources of the yield premium on these ETFs and CEFs can generally be categorized into five buckets:
Income-Focused Property Type – Portfolios tilted towards property sectors with naturally higher payout ratios and/or lower long-term growth prospects.
Small-Cap Tilt – Portfolios tilted towards REITs with smaller market capitalization, which tend to be priced at relative discounts and have higher dividend yields.
Company Risk – Portfolios tilted towards REITs that have elevated idiosyncratic risks such as corporate governance (i.e., externally managed) or tenant quality issues.
Mortgage REITs: Portfolios tilted towards REITs that use a higher degree of leverage, notably mortgage REITs, which typically use 2x-3x higher leverage than equity REITs.
Use of Leverage (CEFs Only) – While ETFs cannot use leverage, Closed-End Funds can add leverage to amplify returns – both on the upside and the downside.
Dividend Cuts Among Seven High Yield REIT ETFs
We introduce and analyze seven high-yield REIT ETFs that offer (trailing) dividend yields ranging from 5-12%, but again point out that these TTM yields likely overstate the “true” forward yield by 100-500 basis points. For that reason, we also note the percentage of the fund’s holdings that have cut or reduced dividends in 2020.
The iShares Mortgage Real Estate Capped ETF (REM) tracks a market cap-weighted index of residential and commercial mortgage REITs. Roughly 75% of the fund’s 36 holdings cut or reduced dividends in 2020.
The VanEck Vectors Mortgage REIT Income ETF (MORT), similar to REM, tracks a market cap-weighted index of mortgage REITs. Like REM, roughly 70% of the fund’s 26 holdings cut or reduced dividends in 2020.
The Global X SuperDividend REIT ETF (SRET) tracks an equal-weighted index primarily composed of US mortgage REITs and non-US retail real estate operators. 25 of the 30 names (83%) in the index as of the start of the year cut or reduced dividends.
The Invesco KBW Premium Yield Equity REIT ETF (KBWY) tracks a dividend yield-weighted index of small- and mid-cap equity REITs. By our tally, 19 of the 30 names (63%) in the index cut or reduced dividends in 2020.
The IQ U.S. Real Estate Small Cap ETF (ROOF) tracks a market cap-weighted index of small-cap equity and mortgage REITs. We calculate that 51 of the 83 names (61%) in the index cut or reduced dividends in 2020.
The InfraCap REIT Preferred ETF (PFFR) tracks a market cap-weighted index of US-listed preferred securities issued by real estate investment trusts. Only 2 of the 98 (2%) preferreds held by the fund are currently suspended. However, it should be noted that more than 75% of these respective issuer’s common stock has been suspended or reduced in 2020.
The ALPS REIT Dividend Dogs ETF (RDOG) tracks an equal-weighted index, applying the popular “Dogs of the Dow” strategy to the REIT sector. We note that 18 of 45 (40%) holdings cut or reduced dividends in 2020.
Readers of our research know that we put heavy emphasis on property sector analysis, recognizing that sector allocations are the single-largest determinant of relative real estate portfolio performance. We note the sector distributions of these funds below. (Note: Pre-pandemic data as of January 2020)
For Real Estate CEFs, Leverage Has Been An Issue
We also introduce and analyze nine of the most popular real estate closed-end funds that offer trailing dividend yields ranging from 8% to 12%. Again, like the high-yield ETFs, we believe that the forward dividend yield achieved is likely significantly overstated due to the wave of dividend cuts over the last six months, but exact figures are difficult to ascertain because, unlike ETFs, CEFs are not “fully transparent” in their holdings disclosure. Also of note, these nine CEFs charge an average expense ratio of over 2.0% – well above the ETF average of less than 0.5% – but have declined by an average of 25% in 2020.
Because of the “capital stability” inherent with the closed-end structure of the fund, however, funds can issue debt to achieve a target leverage factor. The CEF structure is also relatively more conducive to investments in relatively less liquid (and potentially less volatile and higher-yielding) securities, which may expand an active manager’s potential investment universe. As a result, Real Estate CEFs typically hold a broader range of securities than ETFs, including preferreds, convertibles, and bonds, which likely served to buffer some of the downside to the common equity which was amplified by the leverage effects. Even so, these CEFs have significantly underperformed most real estate CEFs in 2020 despite charging fees 4x higher, on average. Below, we note the portfolio characteristics of these nine funds.
The Cohen & Steers Quality Income Realty Fund (RQI), the largest CEF in the group, invests primarily in US equity REITs with a small sleeve of preferred with a leverage factor of roughly 1.25x. Based on publicly available data, we estimate that roughly 20-30% of the portfolio cut or reduced dividends this year.
The Cohen & Steers REIT & Preferred Income Fund (RNP) invests in US and international equity REITs, as well as a healthy mix of real estate bonds and preferred stocks with a similar leverage factor of 1.26x. We estimate that roughly 15-25% of the portfolio cut or reduced dividends this year.
The Cohen & Steers Total Return Realty Fund (RFI) is more akin to a traditional equity and preferred REIT mutual fund, utilizing no leverage. We estimate that roughly 20-30% of the portfolio cut or reduced dividends this year.
The CBRE Clarion Global Real Estate Income Fund (IGR) invests in a diversified mix of US and international equity REITs and preferred stock and utilizes a leverage factor of roughly 1.16x. We estimate that roughly 25-35% of the portfolio cut or reduced dividends this year.
The Aberdeen Global Premier Properties Fund (AWP) invests in a diversified portfolio of common stock of US and international equity REITs, but does so without utilizing leverage. We estimate that roughly 30-40% of the portfolio cut or reduced dividends this year.
The Nuveen Real Estate Income Fund (JRS) allocates a hefty 40% towards real estate preferred securities with the rest invested in a basket of US and international commons stock of REITs with a leverage factor of roughly 1.29x. We estimate that roughly 25-35% of the portfolio cut or reduced dividends this year.
The Neuberger Berman Real Estate Securities Income Fund (NRO) uses a similar 1.31x leverage factor and invests in a similar blend of US and international common and preferred real estate securities. We estimate that roughly 25-35% of the portfolio cut or reduced dividends this year.
The Nuveen Diversified Dividend & Income Fund (JDD) invests in a real estate portfolio heavy in bonds and preferreds and uses leverage factor of roughly 1.32x We estimate that roughly 10-20% of the portfolio cut or reduced dividends this year.
The Principal Real Estate Inc Fund (PGZ), like JDD, also has a bond-heavy portfolio – composing more than half of the fund – and uses a leverage factor of roughly 1.31x. We estimate that roughly 10-20% of the portfolio cut or reduced dividends this year.
Key Takeaways: No Free Lunch On Wall Street
On Wall Street, there’s no free lunch. High-yield funds been slammed by the coronavirus pandemic, bearing the brunt of the wave of dividend cuts that has bedeviled the sector. While roughly a third of the equity REIT sector cut or reduced dividends in 2020, many of these high-yield ETFs and CEF saw 60-85% of their constituents cut dividends this year. These ETFs typically include a collection of misfits, outcasts, small-caps, and recent underachievers. CEFs add another dimension by utilizing leverage. Understanding the source of excess yield is essential.
While the allure of high yield ETF and CEFs can be tempting, we stress that there are no shortcuts in REIT investing, and our research shows that focusing instead on total return and long-term dividend growth can indeed “tilt the playing field” in one’s favor. For investors that absolutely need the income, however, diversification is absolutely critical to minimize elevated idiosyncratic risks, making real estate ETFs an efficient and low-cost option that offers instant diversification.
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Disclosure: Hoya Capital Real Estate advises an Exchange-Traded Fund listed on the NYSE. In addition to any long positions listed below, Hoya Capital is long all components in the Hoya Capital Housing 100 Index. Index definitions and a complete list of holdings are available on our website.
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Disclosure: I am/we are long HOMZ, AMT, ARE, AVB, BXMT, DRE, DLR, EFG, EQIX, FB, FR, MAR, MGP, NLY, NHI, NNN, PLD, REG, ROIC, SBRA, SPG, SRC, STOR, STWD, PSA, EXR, AMH, CUBE, ELS, MAA, UDR, SUI, CPT, NVR, EQR, INVH, ESS, PEAK, LEN, DHI, HST, AIV, MDC, ACC, PHM, TPH, MTH, WELL. 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.
Additional disclosure: Hoya Capital Real Estate (“Hoya Capital”) is an SEC-registered investment advisory firm that provides investment management services to ETFs, individuals, and institutions, focusing on portfolio and index management of publicly traded securities in the residential and commercial real estate industries. A complete discussion of important disclosures is available on our website (www.HoyaCapital.com) and on Hoya Capital’s Seeking Alpha Profile Page.
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