Real estate investment trusts (REITs) have enjoyed a period of low volatility over the last several years as the Federal Reserve-induced "zero interest rate policy" has stimulated asset prices. This has led to continued expansion and investment in office, medical, and apartment complexes that these REITs directly control. However, the recent spike in interest rates has created the first signs of volatility in real estate stocks, which may be an excellent opportunity to profit from this sector.
Two of the largest ETFs in the real estate space are the iShares Dow Jones US Real Estate ETF (IYR) and the Vanguard REIT ETF (VNQ). IYR controls over $5.7 billion in total assets invested in 94 publicly traded REITs, while VNQ invests in a broader subset of 121 real estate stocks with over $20 billion in assets. While the underlying holdings are quite similar, VNQ has the advantage of a miniscule 0.10% expense ratio as compared to 0.47% for IYR.
The below chart of IYR shows how this ETF had a tremendous rise in 2013, which subsequently tapered to a very swift correction. The fund currently sits nearly 10% off of its year-to-date high and is very close to its 200-day moving average.
This pullback in real estate stocks coincided with one of the most volatile months we have seen in the 10-year treasury yield, which rocketed from a low of 1.6% in May to a new breakout high of over 2.2%. This has put tremendous downward pressure on all interest rate-sensitive investments such as commercial REITs, mortgage REITs, utilities, and fixed income, to name a few. However, that same volatility has helped to work off some of the overbought momentum in these sectors.
From a valuation standpoint, IYR and VNQ are much more attractive at these levels than a diversified dividend ETF such as the iShares Dow Jones Select Dividend ETF (DVY), which is less than 4% off of its high. In addition, these REIT ETFs pay a comparable yield to DVY, which is approximately 3.5% annually. In my opinion, if interest rates can stabilize, this correction in IYR and VNQ will be an excellent opportunity to add this sector to your equity income portfolio. The key will be whether or not they can hold their 200-day moving averages and begin new uptrends.
Aggressive income seekers might be tempted by the double-digit yields of the iShares Mortgage REIT Capped ETF (REM). However, this fund has experienced an even steeper decline, which makes me hesitant to recommend it at this juncture. REM is currently trading below its long-term trend line, and I believe that there will be additional downside in this sector through the summer months.
An alternative option for conservative investors in the real estate sector is the Fidelity Real Estate Income Fund (FRIFX). This open ended mutual fund is made up of a unique mix of real estate stocks, preferred stocks, mortgage REITs, mortgage backed securities, and other mortgage related debt. I currently own this fund for my own account and have been drawn to it largely because of its diversified asset mix, healthy dividend yield, and lower volatility.
No matter how you aim to play the real estate sector, keep in mind that it will show a high degree of inverse correlation with interest rates. I believe that the majority of the move in rates has already been made, which is why I am watching this sector closely for a potential entry point. Very few people will be able to perfectly time the bottom, which is why I would recommend starting with small allocations and looking to average into them over time. That way, you can take advantage of any additional pullbacks and still have exposure in your portfolio if REITs take off from here.
Read more from David Fabian, Managing Partner at Fabian Capital Management:
A Mid-Year Portfolio Strategy Discussion
Why High-Yield ETFs Have Stumbled and How to Play Them
Don't Let Conviction Destroy Your Portfolio