Can REIT ETFs Withstand Higher Rates? - ETF News And Commentary

The turbulence in the world economy is not even caring to mellow down, and one nation after another from both sides of the globe are falling victim to it. As market watchers seek a solution to the debt crisis in Greece, which is nearing its climax, an equity bubble in China has cropped up, leading to further worries.
 
Despite the weakening of the broader economy, the China equity market had a phenomenal run this year before crashing lately. And economists around the globe are apprehensive of a contagion effect of it on the other economies as well. (Read: 3 Sector ETFs to profit from Q2 Earnings)
 
Therefore, despite the silver lining in the domestic economy, the Fed officials sound imprecise and are yet to reach a conclusion on what data would they refer to for a rate hike. Well, they would surely want the economy to be strong enough and the labor market to gain steam before any hike but are skeptical about any premature raise.
 
Amid this, the anticipations for a September hike still rules the market and Wall Street economists remain hopeful of a change in the economic landscape not only in the U.S. but around the globe.
 
However, in the near term, the market is expected to remain volatile and fluctuations in treasury yields are likely to continue. And the spillover effect on the real estate investment (REIT) industry is bound to persist.
 
REITs Take a Hit

Though REITs have emerged as a winner last year among the widespread volatility and even outperformed the broader equity market in January, as of May 29, 2015, the total return of the FTSE NAREIT All REITs Index dipped 0.96% as against the S&P 500 Index’s total return of 3.23%.
 
While volatility seems to have eaten away much of the broader equity market gains this year, the impact on the REIT stocks has been more pronounced.

Rising Rates and Economic Strength

A rise in interest rates will undoubtedly lead to a high borrowing cost for the REITs on which they are highly dependent. Moreover, high-dividend yielding stocks like REITs usually become less attractive when treasury yields rise.

But that does not take away opportunities from this sector. This is because the REITs business is tied to the basic necessities of life such as food, housing and health care without which we cannot live for long. They offer real estate on rent for dwelling proposes, warehousing, shopping, dining, vacationing and advertising too.

Now, as Fed plans for a rate hike only when the economy gains strength, employment level improves and inflation reaches target levels, we believe this would open up opportunities for the REIT sector to leverage from improving economic fundamentals.
 
In fact, despite global issues, the domestic economy looks better with stepped-up economic activities, rising business and consumer confidence, an improving job market and recovering housing fundamentals. Further optimism is raised from expectations of a booming retail sector in this second half of 2015. All these uplift economic growth and lead to an upbeat outlook.
 
Well, this stepped-up economic activity also stimulates corporate spending, leading to increased hiring and this greater workforce would need more space for accommodation.

Also, enhanced purchasing power drives more spending on part of individual consumers. This translates into increased industrial activity while their distribution needs logistic facilities, thereby increasing demand for real estate. A fatter wallet also means better rent-paying ability that drives demand for apartments. As a result, REITs stand to gain with growth in occupancy and hike in rents.

But not all markets are equal. A close introspection is needed as the worth of any REIT stock depends much on the asset type in which it invests as well as on the local economy. Therefore, ignoring the short-term jerks, investing in fundamentally strong REIT stocks could be a prudent decision. And the hiccups might offer solid entry points. (Read: Invest in American with These ETFs)
 
Still Dividends Standing Tall

The U.S. law requires REITs to distribute 90% of their annual taxable income in the form of dividends. This has been the biggest enticement for the REIT stocks to gain traction in the recent past amid global uncertainties, both in the money and commodities markets. Though REITs have taken a beating of late, their dividend yield came in better than that of the market.

In fact, at the end of May (May 29), the dividend yield of the FTSE NAREIT All REITs Index was 4.02% while the yield of the FTSE NAREIT All Equity REITs Index was 3.62%. Clearly, the REITs continued to offer decent yields and outpaced the 2.05% dividend yield offered by the S&P 500 as of that date.

Capital Access

REITs were proactive in the capital market in 2014 and are still so in 2015. They have opportunistically drawn leverage from the low rate environment for refinancing their debts, which is encouraging. Also, this indicates the rise in investors’ confidence in this sector and their willingness to pour money into it.

As of May 29, 2015, REITs raised $34.9 billion in initial, debt and equity capital offerings (IPOs - $1.4 billion, Secondary Common - $14.7 billion, Secondary Preferred - $1.8 billion and Secondary Debt - $17.0 billion).
 
Exploring the Sector Through ETFs
 
In this backdrop, we believe this is the right time to explore the sector through ETFs, so as to reap the benefits in a safer way. Considering the return prospects from dividend income and capital appreciation, we have tracked the following REIT ETFs (see all real estate ETFs here) , which could be worth considering:
 
Vanguard REIT ETF (VNQ)
 
The fund, launched in 2004, seeks investment results by tracking the performance of the benchmark – MSCI US REIT Index – which is used to gauge real estate stocks. The fund consists of 145 stocks, which acquire office buildings, hotels, and other real property. The top three holdings are Simon Property Group Inc. (SPG), Public Storage (PSA) and Equity Residential (EQR). It charges 12 basis points (bps) in fees (as of May 28, 2015). VNQ has managed to attract $50.2 billion in assets under management till May 31, 2015.
 
iShares U.S. Real Estate ETF (IYR)
 
Launched in 2000, IYR follows the Dow Jones U.S. Real Estate Index that measures the performance of the real estate industry of the U.S. equity market. The fund comprises 115 stocks with top holdings including Simon Property Group Inc., American Tower Corporation (AMT) and Public Storage (PSA). The fund’s expense ratio is 0.43% (as of Mar 31, 2015) and the 12-month trailing yield is 3.86% (as of Jun 30, 2015). It has around $4.4 billion in assets under management as of Jul 8, 2015.
 
SPDR Dow Jones REIT ETF (RWR)
 
Functioning since 2001, RWR seeks investment results of the Dow Jones U.S. Select REIT Index. The fund consists of 93 stocks that have equity ownership and operate commercial real estate, with the top holdings being Simon Property Group Inc., Public Storage and Equity Residential. The fund’s expense ratio is 0.25% (as of Jul 9, 2015) and dividend yield is 3.20% (as of Jul 7, 2015). RWR has about $3.0 billion in assets under management (as of Jul 7, 2015).
 
Schwab US REIT ETF (SCHH)
 
This fund debuted in 2011 and tracks the total return of the Dow Jones U.S. Select REIT Index. The fund consists of 99 stocks that own and operate commercial real estates. The top three holdings are Simon Property Group Inc., Public Storage and Equity Residential. It charges 7 bps in fees (as of Jun 30, 2015), while the trailing twelfth month distribution yield is 2.18%. SCHH boasts $1.5 billion in assets under management (till Jul 8, 2015).
 
First Trust S&P REIT Index Fund (FRI)
 
Launched in May 2007, FRI is an ETF that seeks investment results of the S&P United States REIT Index, which gauges the U.S. REIT market and retains consistency, depicting the overall market composition. The fund comprises 154 stocks with the top holdings being Simon Property Group Inc., Public Storage and Equity Residential. The fund’s net expense ratio is 0.50% (as of May 1, 2015) and the 12-month distribution rate is 2.12% (as of May 29, 2015). FRI has about $216.4 million in net assets under management (as of Jul 7, 2015).   
 
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VIPERS-REIT (VNQ): ETF Research Reports
 
ISHARS-US REAL (IYR): ETF Research Reports
 
SCHWAB-US REIT (SCHH): ETF Research Reports
 
SPDR-DJ W REIT (RWR): ETF Research Reports
 
FT-SP REIT IDX (FRI): ETF Research Reports
 
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