Another fund within this property-focused grouping, the Real Estate Select Sector SPDR Fund (XLRE), tracks the S&P Real Estate Select Sector index comprising the 33 REIT stocks within the S&P 500. It has a pleasingly low 0.14% expense ratio and, like the iShares U.S. Real Estate ETF, has significant exposure—16% of its portfolio—to the cell tower REITs: American Tower and Crown Castle. Investors in this fund will miss mid-cap and small-cap REIT exposure, but the fund will provide a dose of the REIT sector as represented in the S&P 500.
Diversification And Dividends
This brings us to the big reasons many investors own dedicated REIT funds—diversification and dividends. The diversification argument holds that a dose of REITs beyond what exists in a broadly diversified stock fund may provide diversification, thus boosting a portfolio’s volatility-adjusted returns. It turns out that’s partly correct. A recent study by Jared Kizer and Sean Grover of Buckingham Asset Management shows that REITs provide some diversification, though not in doses exceeding their weightings in broad market indexes, which is around 3%.
But for income-seeking investors, the dividend argument can still be a reason for adding REIT funds to their portfolios. While dividends make property REITs somewhat bond-like and somewhat interest rate sensitive, they are not as sensitive as mortgage REITs, whose entire business model depends on a steep yield curve. Also, property REITs can raise rents in rising interest rate or inflationary environments, allowing them to deliver higher dividends to investors.
But REIT investors should familiarize themselves with one idiosyncrasy of REIT accounting. Namely, there is usually a large and unrealistic depreciation charge running through REIT income statements that deflates net income considerably. That means investors trying to understand whether a REIT or a group of REITs can cover the dividends they’re paying should look at a metric called “funds from operations,” or FFO. It adds back the depreciation charge to net income. It also subtracts the gains earned from property sales, since sales don’t indicate how existing properties are performing. Investors should want to know if funds from operations—i.e., money left after collecting rent and paying expenses—are covering dividends.
There are a lot of real estate ETFs, but investors seeking straightforward commercial property exposure to dividend-paying property REITs can narrow it down to those few funds that deliver just that. Happily, those funds don’t charge expenses that resemble Park Avenue rents.
John Coumarianos, a former Morningstar analyst, is a financial writer in Laguna Niguel, Calif.