Ivo Kolchev On VNQ Vs. VNQI For Dividend Investors

Key Concepts

VNQ (Vanguard Real Estate Index Fund ETF Shares): An ETF tracking U.S. real estate investment trusts (REITs).
VNQI (Vanguard Global ex-US Real Estate Index Shares): An ETF tracking global real estate markets outside of the U.S.
Book Value: The value of an asset as recorded on a company's balance sheet, often adjusted for depreciation in the U.S.
Fair Value: The estimated price an asset would sell for on the open market, typically determined by independent appraisers internationally.
Dividend Yield: The annual dividend payment per share divided by the stock's price.
Interest Rate Cycle: The pattern of rising and falling interest rates set by central banks, impacting borrowing costs and investment returns.
Currency Fluctuations: Changes in the exchange rate between different currencies, affecting the value of international investments when converted back to a domestic currency.
Payout Ratio: The proportion of a company's earnings or cash flow paid out to shareholders as dividends.
Market Capitalization: The total market value of a company's outstanding shares.
Geopolitical Risk: Risks arising from political instability, conflicts, or international relations in different countries.
Emerging Markets: Countries with developing economies that offer high growth potential but also higher volatility.

U.S. vs. International Real Estate Markets: A Comparative Analysis

This discussion, featuring Seeking Alpha Analyst Ivo Kolchev and host Daniel Snyder, delves into a comparative analysis of U.S. real estate investment (represented by VNQ) versus international real estate investment (represented by VNQI). The core of the analysis revolves around valuation differences, interest rate impacts, currency risks, dividend sustainability, sector composition, and geopolitical considerations.

Accounting and Valuation Differences

A fundamental distinction highlighted is the difference in accounting approaches between U.S. and international real estate markets.

U.S. Real Estate: Typically held at book value minus depreciation. This method can lead to a less current reflection of an asset's true market worth.
International Markets: Real estate is generally held at fair value, determined by independent appraisers approximately every six months. This provides a more up-to-date valuation.

Key Point: For international REITs, book value is considered a more useful metric for valuation compared to U.S. markets due to the fair value accounting.

Investment Thesis for International REITs

Ivo Kolchev's thesis for international REITs outperforming U.S. REITs is based on two primary factors:

Discount to Book Value: International REITs are currently trading at approximately a 10% discount to their book value. This suggests they are undervalued relative to their underlying assets.
Higher Current Dividend Yield: International REITs offer a slightly higher current dividend yield compared to their U.S. counterparts.

Impact of Interest Rates on Real Estate

The conversation addresses the significant impact of interest rate cycles on real estate markets.

Past Performance (Last 10 Years): Both VNQ and VNQI have exhibited slow dividend growth, in the low single digits. This was largely attributed to REITs needing to refinance debt at higher interest rates, which constrained their ability to increase distributions.
Future Outlook (Next 10 Years): With the current trend of declining interest rates (both in the U.S. and internationally), Kolchev expects dividend growth to accelerate for both ETFs.
Near-Term U.S. Effect: As interest rates fall, money market fund yields (which were around 5% last year, now closer to 4%, and potentially 3% next year) become less attractive. This could lead to capital flowing into dividend-paying assets like REITs, making their current dividend yields (around 4% for VNQ) more appealing.

Currency Fluctuations and Return Components

Currency risk is a significant consideration for U.S. investors in international markets.

Current Year Driver: The weak U.S. dollar has been the primary driver of returns for international REITs in the current year.
Future Expectations: Kolchev anticipates some further dollar weakness in the future, driven by interest rate cuts and geopolitical risks. However, he expects this currency tailwind to be small and uncertain, providing a minor benefit to international REIT returns when measured in U.S. dollars.
Return Components Breakdown: Kolchev divides investment returns into three components:
1. Current Dividend: The most certain component, as REITs aim to set sustainable dividends.
2. Gains in Real Estate Value: Appreciation of the underlying properties.
3. Currency Tailwind: The impact of currency exchange rate movements. The currency tailwind is considered the most uncertain.

Dividend Sustainability

The sustainability of dividends is a crucial aspect for investors.

Vanguard's Disclosure: Vanguard does not disclose payout ratios for its ETFs, making direct comparison of dividend sustainability between VNQI and VNQ difficult.
General Expectation: Kolchev generally expects that companies, both in the U.S. and internationally, set dividends at sustainable levels that they can maintain and potentially grow.
Link to Valuation: The slightly higher yield for international REITs is linked to their trading at a discount to book value.

Sector Composition and Future Trends

The underlying holdings of the ETFs are also examined.

VNQ Top Sectors: The top three sectors within VNQ are healthcare, retail, and telecom towers.
Future Rotation: Regarding potential future rotations, Kolchev notes that ETFs like VNQ are passively managed and track market capitalization. If trends like the shift from traditional cell towers to satellite technology emerge, the market cap of telecom REITs might shrink, while data center REITs might grow. This would naturally lead to a gradual shift in the ETF's holdings over time, not an immediate one.

Geopolitical Risks and Emerging Markets

The international ETF, VNQI, includes exposure to various countries, with Japan, Australia, Hong Kong, the United Kingdom, and Singapore being the top five.

Emerging Markets Exposure: VNQI has approximately 20% exposure to emerging markets.
Risk vs. Opportunity: While emerging markets present higher geopolitical risk and volatility, they also offer significant opportunities due to their higher GDP growth rates. This is where real estate values are expected to increase the most, potentially leading to higher long-term returns.

Investment Pick: VNQI

When pressed to choose between VNQ and VNQI for an investment today, Kolchev selects VNQI. His reasoning is based on:

Slightly higher current dividend yield.
International REITs trading at a discount to book value.
Expectation of further U.S. dollar weakening, providing a currency tailwind over the next few years (though not as pronounced as in the recent past).

Conclusion and Key Takeaways

The discussion emphasizes that while U.S. and international real estate markets share similarities, crucial differences in accounting, valuation, and currency dynamics necessitate distinct analytical approaches. Kolchev's analysis suggests that international REITs, represented by VNQI, currently present a compelling investment case due to their undervaluation relative to book value and a slightly higher dividend yield, coupled with potential currency tailwinds. Investors are advised to consider the trade-offs between the certainty of dividends, potential for capital appreciation, and the inherent uncertainties of currency fluctuations and geopolitical risks. The passive nature of these ETFs means sector rotations will occur organically as market capitalizations shift over time.