Real Estate ETFs Rejoice Amid Low Rates

Real estate investment trusts and related exchange traded funds are capitalizing on the low interest-rate environment, and the market could find further support ahead as REITs become the newest S&P 500 sector.

REITs are firms that trade like a stock and invest in real estate directly through property ownership or mortgages. Consequently, company revenue is largely generated through rents or interest on loans. To qualify for special tax considerations, the asset also distributes the majority of income, about 90% of taxable profits, to investors as dividends, which has made the asset an attractive alternative for income seekers.

A Federal Reserve interest rate hike is the largest risk the REITs industry has faced. While the high dividend yields in REITs are attractive in a low-rate environment, the asset is less enticing once safer Treasuries show higher rates. Moreover, as rates rise, REIT interest payments also rise, so firms are left with less cash flow available for dividends.

For now, REITs have been rebounding after a dovish Fed anticipated only two rate hikes this year from a previously expected four increases. The weak April jobs report has also fueled expectations that the economy may not be strong enough to support further rate hikes, potentially diminishing the likelihood the Fed would change its benchmark rates in the upcoming June meeting. If the Fed does decide to push off interest rate normalization, investors may continue to steer toward REITs for yields.

Further supporting the REITs outlook, the S&P Dow Jones Indices stated it would add an 11th sector to its Global Industry Classification Standard, creating a new Real Estate Sector from the Financial Sector. The changes to the S&P 500 index is expected to be implemented after the close of business on September 16, 2016. The changes will impact the way investors conduct sector investing and potentially add an additional $100 billion or more into the newly formed REIT sector as fund managers re-allocate assets in response to their sector investment guidelines.

For diversified REITs exposure, investors have looked at broad options like Vanguard REIT ETF (NYSE:VNQ) and iShares Dow Jones US Real Estate Index Fund (NYSE:IYR). VNQ tries to reflect the performance of the MSCI US REIT Index, which includes all domestic REITs from the broader MSCI U.S. Investable Market 2500 Index. However, mortgage REITs and non-real-estate specialty REITs are not included. The fund's sub-sector breakdown includes diversified REITs 8.0%, health care REITs 12.0%, hotel & resort REITs 5.5%, industrial REITs 4.5%, office REITs 12.0%, residential REITs 16.5%, retail REITs 24.9% and specialized REITs 16.5%. The ETF has a 0.12% expense ratio and a 4.32% 12-month yield.

The broader IYR tracks the Dow Jones U.S. Real Estate Index, which holds all domestic REITs, including mortgage REITs and non-real-estate specialty REITs. Sub-sector weights include specialized REITs 26.8%, retail REITs 20.0%, residential REITs 13.4%, office REITs 10.1%, health care REITs 9.7%, diversified REITs 5.1%, mortgage REITs 4.7%, hotel & resort REITs 3.9%, industrial REITs and real estate services 2.1%. IYR has a 0.43% expense ratio and a 4.17% 12-month yield.

Alternatively, investors may also consider targeted REIT ETF options. For instance, the iShares Mortgage Real Estate Capped ETF (NYSE:REM) and VanEck Vectors Mortgage REIT Income ETF (NYSE:MORT) focus on mortgage REITs or mREITs. REM has a 0.48% expense ratio and a 11.39% 12-month yield. MORT shows a 0.41% expense ratio and a 9.61% 12-month yield.

While REM and MORT offer attractive high yields, mortgage REITs are more susceptible to rising interest rate risks and a flattening yield curve. Mortgage REITs generate revenue by using leverage to capitalize on the spread between short- and long-term interest rates. Consequently, if short-term rates rise or long-term rates decline, the diminished spread would hurt mREITs.

Additionally, investors may also be interested in international REIT ETF exposure as foreign central banks engage in zero or negative interest rate policies. With global central banks depressing rates, foreign investors may turn to riskier assets, like REITs, in search of better income sources. Consequently, the greater demand could support gains in international REIT ETFs, such as the SPDR Dow Jones International Real Estate ETF (NYSE:RWX) and Vanguard Global ex-U.S. Real Estate ETF (NYSEA:VNQI).

RWX, which tracks the Dow Jones Global ex-U.S. Select Real Estate Securities Index, includes large a hefty 23.4% tilt toward Japan and 31.6% to Europe, areas where central banks have enacted negative interest rate policies. Additionally, the fund includes 15.4% to Australia, which recently saw interest rates cut to a new low. The ETF has a 0.59% expense ratio and a 2.70% 12-month yield.

VNQI, which follows the S&P Global ex-U.S. Property Index, also includes 24.3% Japan, 26.1% developed Europe and 11.3% Australia exposure. The fund has a 0.18% expense ratio and a 2.78% 12-month yield.

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