Except for a brief period during the first technology bubble when real estate investment trusts were left for dead, real estate never seems to go out of favor. Investors have a perpetual hankering for bricks and mortar.
Even now, when a new group of technology stocks—the so-called FAANGs, or Facebook, Apple, Amazon, Netflix and Google—have captured investors’ imaginations, REITs are holding their own. From 2009 through 2017, the Vanguard REIT ETF (VNQ) delivered a hefty 14.3% annualized return, or a 232% cumulative return, to investors without a negative calendar year. The fund gained 4.91% in 2017.
But there are many real estate exchange-traded funds, and it’s hard to know what you’re getting without doing some due diligence. An asset class that has spanned the eons is now sliced, diced and packaged in many ways for prospective investors. This article will clue you in to what some of the biggest funds offer in terms of property REITs, mortgage REITs and real estate operating companies.
First, some basics. REITs are stocks of companies that hold real estate or real estate-related investments such as mortgages. A company organized as a REIT holds property or mortgages and avoids income tax at the corporate level. In exchange for that benefit, the company must pay out 90% of its net income as a dividend to shareholders. As a result, REIT dividends are taxed as ordinary income at the level of the individual investor, making them better to hold in tax-advantaged accounts.
REITs, REOCs, Mortgages And VNQ’s Problems
Job one for investors in this space is to distinguish between mortgage REITs and property (equity) REITs. The former are firms that borrow money to buy mortgages or mortgage-backed securities. Often, like a bank, a mortgage REIT has borrowed up to 90% of the value of its assets. This business model aims to exploit a steep yield curve by borrowing short-term and holding longer-term mortgages. The largest mortgage REIT is Annaly Capital (NLY). The iShares Mortgage Real Estate Capped ETF (REM), with more than $1 billion in assets, is a popular ETF dedicated to this segment of the REIT market. Annaly is the fund’s largest holding, representing 18% of its assets.
Mortgage REITs tend to have bigger yields than property REITs, but they aren’t what most investors think about when trying to diversify their portfolio with real estate. Because of the short-term nature of their loans, they depend on available credit—and can get crushed when credit markets tighten up. They got hammered, for example, during the credit crisis. As a result, REM has a 10-year annualized return of 2.01% through the end of 2017, and was up 18.54% for 2017. The low long-term return of REM, combined with its high volatility, results in a meager 10-year Sharpe ratio of 0.18. VNQ’s 10-year Sharpe ratio, by contrast, is a little more than double REM’s at 0.41, meaning it has much better returns per unit of volatility.
Investors should carefully scrutinize REIT funds with the highest yields because they often contain a large slug of mortgage REITs. This includes funds such as the Global X SuperDividend REIT ETF (SRET), which consists of 30 of the highest-yielding REITs globally. In fact, nearly half of this fund’s portfolio is mortgage REITs, and investors who purchase it and others like it without doing their homework may be getting a group of highly levered, ultra-interest-rate-sensitive companies.
What most investors are really looking for when they buy a REIT fund is a product that owns property. And that’s a broad category encompassing apartment buildings, office buildings, industrial space, hotels, malls, self-storage space, medical and laboratory space, cinemas, gas stations, single-family homes, farmland and computer equipment warehousing space, among other types.
Instead of having a thin equity layer against a lot of borrowed money like mortgage REITs do, property REITs generally have borrowed 40% to 60% of their asset value. That’s not a small amount, but it’s less than the 90% of a mortgage REIT, and it’s also typically much longer-term debt. Borrowing half the value of occupied properties for, say, seven years is a much less risky proposition than borrowing 90% of the value of a pile of mortgages for six months. If the credit markets dry up, the mortgages have to be sold at any price.