Why REIT ETFs Still Work as Real Estate Slumps

Key Concepts

• REIT (Real Estate Investment Trust): Companies that own, operate, or finance income-producing real estate.
• REIT ETF (Real Estate Investment Trust ETF): Exchange-traded funds that invest in a basket of REITs, offering diversification and liquidity.
• Passive vs. Active ETFs: Passive ETFs track an index, while active ETFs are managed by a portfolio manager aiming to outperform the market.
• Yield: The income return on an investment, particularly important for REITs due to their payout requirements.
• Tax Implications: REIT distributions are generally taxed as ordinary income for investors.
• Interest Rate Sensitivity: REITs are significantly affected by changes in interest rates due to their financing needs.

REIT ETFs: A Deep Dive into Income Investing

Introduction

The real estate sector, including REITs and REIT ETFs, has faced headwinds from elevated inflation and high interest rates in recent years. Despite this, REIT ETFs remain popular among income investors due to their potential for cash generation and portfolio diversification. This discussion with Dan Satir, Associate Director of US Passive Strategies at Morningstar, explores the intricacies of REIT ETFs, their performance, and how they fit into an income-focused investment strategy.

What are REIT ETFs and How Do They Work?

REITs are publicly traded companies that invest in real estate – encompassing diverse property types like shopping malls, office centers, data centers, warehouses, and cell phone towers. Essentially, they allow investors to participate in the economics of real estate ownership without the direct responsibilities of property management, maintenance, and tenant relations. As Dan Satir explains, “it’s sort of like if you’re a landlord…except you’re outsourcing the…upkeep and all that stuff.”

Distinguishing REITs from Other Stocks

REITs operate under a unique structure with specific tax benefits. They are granted a tax break, but in return, they are required to distribute a significant portion of their taxable income to shareholders. This results in higher yields for investors, but also means the tax burden shifts from the company to the individual investor. “The tax is still getting paid to the government. It's just the burden is put on to the investors at the end of the day rather than the company,” Satir clarifies. This distribution requirement influences their financing and business operations.

REIT ETF Strategies: Passive vs. Active

REIT ETF strategies fall into two main categories: passive and active.

• Passive ETFs: These funds track a specific REIT index, providing broad market exposure. Some may include real estate-adjacent companies like Zillow or CBRE Group, expanding the investment universe slightly.
• Active ETFs: Active managers have more flexibility, potentially including companies where real estate is a significant component of the business (e.g., casinos) but aren’t strictly REITs. This allows for a broader investment scope but requires careful evaluation of performance drivers.

The question of whether the higher fees associated with active REIT ETFs are justified is nuanced. While active managers have shown a slightly higher success rate in the real estate category, investors must scrutinize how that outperformance is achieved. If it comes from investing in non-REIT companies, the yield may be lower, defeating the purpose for income-focused investors. “Are you actually after total return or are you actually after income at the end of the day and make your decision accordingly?” Satir advises.

Performance Analysis: Absolute and Relative Returns

Over the past 15 years (post-Global Financial Crisis to present), REIT ETFs have delivered a total return of slightly over 7% annually. However, they have underperformed the broader market by approximately 6% per year during the same period. This underperformance is largely attributed to the dominance of technology companies in the market over the last decade.

More recently, the period since 2022 has been particularly challenging for REIT ETFs. The fight against inflation and subsequent interest rate hikes have significantly impacted the sector. REIT ETFs lost about 2.8% over the four years through December 2023, underperforming the broader market by 13%. This sensitivity to interest rates stems from REITs’ reliance on financing for property acquisition and development. “They’re going to be very sensitive to the interest rate cycle,” Satir explains, drawing a parallel to the impact of rising mortgage rates on individual homebuyers.

Tax Considerations for Income Investors

REIT distributions are typically taxed as ordinary income, meaning investors should prioritize holding these investments in tax-deferred accounts like IRAs or 401(k)s for long-term growth. For investors relying on income from distributions, there are limited opportunities to minimize tax liabilities. “There’s no way to like get crafty and avoid the taxes on this. You’re going to have to pay…income taxes if you take the distributions,” Satir states. Investors should be prepared for a 1099 form detailing their distributions.

Top REIT ETF Picks from Morningstar

Morningstar analysts highlight several REIT ETFs as strong contenders:

• Vanguard Real Estate ETF (VNQ): With approximately $35 billion in assets, VNQ is a market leader. It receives a Silver rating from Morningstar. It has a broader scope than some other ETFs, including real estate-adjacent companies.
• Schwab US REIT ETF (SCH): Managing around $9 billion, SCH focuses exclusively on REITs and also holds a Silver rating.
• Dimensional Real Estate ETF (DF): This actively managed ETF, with $1.5 billion in assets, employs a more deliberate trading strategy and also receives a Silver rating.

For investors seeking international exposure, the Vanguard Global ex-US Real Estate ETF (VNQI) is recommended as a starting point.

Portfolio Allocation and Final Thoughts

Satir emphasizes the importance of careful portfolio allocation. The real estate sector represents a relatively small portion of the overall market (2-3%), so investors should avoid over-allocating to REIT ETFs. He suggests starting with broad index funds to understand the sector’s risk-return profile before considering active management strategies. He also points out that alternative dividend-focused strategies may offer broader market exposure without the concentrated sector bet inherent in REITs.

Conclusion

REIT ETFs offer a convenient way to gain exposure to the real estate market and generate income. However, investors must understand the unique characteristics of REITs, including their tax implications and sensitivity to interest rates. Careful consideration of investment strategies, fund selection, and portfolio allocation is crucial for maximizing returns and achieving income goals.