USRT: REIT Fans Claim 3 Reasons To Buy - I'm Not Convinced

seekingalpha05-15

iShares Core U.S. REIT ETF warrants a hold rating due to lack of convincing reasons to buy.REITs have underperformed the market and face challenges in the post-COVID environment, including work-from-...

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Dragon ClawsInvestment Thesis iShares Core U.S. REIT ETF (NYSEARCA:USRT) warrants a hold rating due to a lack of convincing reasons to buy. REIT advocates promote buying right now due to the expected reduction in interest rates, subsequent real estate and economic growth, and benefits of REIT investment versus actual real estate ownership. However, there are signs that interest rates will remain elevated above the previously seen 2020 levels while fundamental post-COVID real estate issues linger. Additionally, the benefits of REITs versus actual real estate are, in some respects, overblown. Fund Overview and Compared ETFs REITs, or Real Estate Investment Trusts, have benefited investors by providing diversified exposure to various real estate sectors without the risks associated with direct physical ownership. REITs also normally provide an attractive dividend yield, as the companies provide at least 90% of their taxable income to shareholders. USRT is a passively managed exchange-traded fund, or ETF, that captures REIT holdings by tracking the FTSE Nareit Equity REITS Index. With its inception in 2007, the fund has 130 holdings and $2.33B in AUM. The fund is rebalanced quarterly and is predominantly focused on Retail REITs (16.81%), Industrial REITs (14.24%), and Multi-family Residential REITs (12.00%). For comparison purposes, other funds examined are the Schwab U.S. REIT ETF (SCHH), the Vanguard Real Estate ETF (VNQ), and the Invesco Active U.S. Real Estate ETF (PSR). These funds were selected based on their popularity and size, with over $1B in AUM. SCHH is heavier on telecom tower REITs (12.98% weight) and lower on retail and industrial REITs than USRT. VNQ is more balanced on REIT sub-industries and is the most diversified with 158 holdings. PSR is the largest REIT fund compared by assets under management, but is also the least diversified. Performance, Expense Ratio, and Dividend Yields Compared USRT has a 10-year average annual return of 6.53% with a total price return of 21.19% over the past decade. This average return is superior to VNQ’s 10-year average annual return of 4.97%, SCHH’s 3.62% and PSR’s 5.08%. All REIT ETFs examined have significantly underperformed the U.S. market, as measured by the S&P 500 Index, which has seen a 10-year average annual return of 12.4%. As I will discuss later, this is predominantly due to significant REIT declines as the U.S. Federal Reserve raised interest rates.   10-Year Total Price Return: USRT and Compared REIT ETFs (Seeking Alpha)All REIT ETFs examined, including USRT, have competitive expense ratios. USRT’s expense ratio is 0.08%, only higher than Schwab’s SCHH fund. Because REITs pay a significant portion of their taxable income to shareholders, their dividend yields have historically been attractive. USRT offers a 3.25% yield, which is on the lower end of its peers. Additionally, USRT’s yield has been declining with a -7.49% 5-year CAGR. Expense Ratio, AUM, and Dividend Yield Comparison     USRT SCHH VNQ PSR   Expense Ratio 0.08% 0.07% 0.12% 0.35%   AUM $2.33B $6.27B $59.37B $65.86B   Dividend Yield TTM 3.25% 3.36% 4.15% 3.21%   Dividend Growth 5 YR CAGR -7.49% 0.85% -0.43% 7.73%   Click to enlarge Source: Seeking Alpha, 14 May 24 USRT Holdings and REIT Outlook Factors USRT and peer REIT ETFs have similar top holdings, including Prologis (PLD), an industrial REIT, and Equinix (EQIX), a data center REIT. VNQ’s top holding is in Vanguard’s Real Estate II Index Fund, or VRTPX, which simply consists of more PLD, American Tower Corporation (AMT), EQIX and the other top holdings found in peer funds. Top 10 Holdings for USRT and Peer REIT Funds   USRT – 130 holdings SCHH – 121 holdings VNQ – 158 holdings PSR – 26 holdings   PLD – 9.56% PLD – 8.06% VRTPX – 13.06% EQIX – 9.18%   EQIX – 6.98% AMT – 7.10% PLD – 7.61% CCI – 7.64%   WELL – 5.30% WELL – 4.64% AMT – 5.82% PLD – 6.86%   SPG – 4.59% EQIX – 4.44% EQIX – 4.90% DOC – 4.97%   O – 4.40% SPG – 4.04% SPG – 3.23% EXR – 4.90%   DLR – 4.29% DLR – 3.90% WELL – 3.16% KIM – 4.88%   PSA – 4.17% O – 3.85% PSA – 2.90% AVB – 4.88%   EXR – 2.98% PSA – 3.69% CCI – 2.90% AMT – 4.83%   VICI – 2.95% CCI – 3.66% O – 2.84% SPG – 4.82%   AVB – 2.69% EXR – 2.63% DLR – 2.67% PSA – 4.76%   Click to enlarge Source: Multiple, compiled by author on 14 May 24 Proponents for buying REITs claim that now is a good time to buy for several reasons. First, falling interest rates will boost REITs by lowering their costs and increasing the comparative attractiveness of their dividends yields. Second, lower interest rates will fuel economic growth, including the prospects for real estate. Third, REIT investment is superior to direct real estate ownership and management. While I partially agree with some of these points, I am not fully convinced. Let’s break down each argument below. Factor #1: Interest Rates The first major variable impacting the outlook for REITs is interest rates. Advocates in favor of buying REITs right now point to the expected decrease in interest rates by the U.S. Federal Reserve. In March 2022, the Federal Reserve started increasing interest rates, leading to their current levels. The last increase was in July 2023, raising the current level to 5.33%. While Federal Reserve Chairman Powell stated earlier this month that another increase is “unlikely,” this does not necessarily mean that significant cuts are coming soon.   Federal Funds Rate, 2019-Present (fred.stlouisfred.org, 14 May 24)Overlaying these increases, we see a clear inverse correlation with REITs. USRT hit its price high in early 2022 at approximately $65 per share. Subsequently, USRT declined strongly in 2022 as interest rates were increased. Furthermore, REITs have underperformed the market since 2022, corresponding to higher interest rates which have elevated the cost of capital. Additionally, rising bond yields and high yield savings accounts have seen more attractive interest rates, in competition to REITs. Therefore, when interest rates fall, REITs will likely be more attractive. However, expecting interest rates to get as low as pre-COVID levels is likely too optimistic. Factor #2: Real Estate & Economic Growth The second reason why advocates may promote REITs is due to the expected economic and real estate growth from lowered interest rates. However, I am not totally sold on this rationale either. While residential real estate may benefit from lower interest rates, there are headwinds with commercial and retail real estate, including work-from-home policies and challenges with brick-and-mortar stores. Hybrid work models where workers only work in the office part of the week has become the new normal in many industries. An estimated 37% of U.S. jobs can be done entirely from home. This puts negative pressure on commercial real estate and traditional office spaces. This has resulted in an office vacancy rate of 18.2%, a 30-year high. Online shopping sales are up 7.16% year-over-year as well, negatively impacting retail real estate. To add to these trends, there is approximately $1.2T of commercial mortgage debt due to mature through 2025. Therefore, while REIT champions point towards expected real estate growth because of declining interest rates, I am not fully convinced that now is the time to buy. Factor #3: REITs vs. Personal Real Estate Ownership The third point REIT advocates argue is that REIT investment has many advantages over direct real estate ownership, including better returns from REITs compared to direct real estate ownership. This is not true in many cases. For example, residential real estate has seen a strong rise in price while REITs have offered muted returns. In 2019, the median U.S. home price in January 2019 was $252,257. In February 2024, it was $405,615, a 60% increase from 2019.   U.S. Median Home Price 2010-2024 (DQYDJ, 14 May 24)In contrast, the total share price increase for USRT over the same period was 18%. Of note, between 2013 and 2023, while the S&P 500 returned a total of 155%, Vanguard’s VNQ returned only 37%. Therefore, REIT investment has presented opportunity cost compared to both direct real estate ownership and broad-based investment in U.S. markets over the past five years. Current Valuation Looking at recent performance, REIT ETFs have been relatively flat over the past year, with USRT seeing a 4.80% return. All funds have seen a 6-month return of roughly 10% on hopes that there will be no more interest rate hikes. Despite this optimism, all funds have significantly underperformed the rest of the market year-to-date.   One Year Performance: USRT and Peer REIT Funds (Seeking Alpha)Despite low recent returns, the valuation of USRT as measured by its price-to-earnings and price-to-book is still relatively high. USRT does have the most attractive valuation, with a P/E of 27.09 and a P/B of 1.99. While this is lower than peer REIT ETFs, it is on par with the U.S. market overall, with the S&P 500’s P/E at 27.27. Valuation Metrics for USRT and Peer REIT ETFs     USRT SCHH VNQ PSR   P/E ratio 27.09 30.71 34.60 36.84   P/B ratio 1.99 2.16 2.40 2.16   Click to enlarge Source: Compiled by Author from Multiple Sources, 14 May 24 In addition to a relatively high valuation, I believe REITs will perform sub-optimally to the rest of the market for the reasons discussed. This would also be consistent to its long-term track record compared to the market overall. Risks to Investors USRT has a 3-year standard deviation of 21.25% and 3-year equity beta value of 1.07. Therefore, the REIT ETF should be considered quite correlated with the market overall and roughly just as volatile. For example, during the outbreak of the COVID pandemic, while the S&P 500 Index saw a 31% decline, USRT saw a 42% decline. Additionally, I believe the greatest risk to USRT is elevated interest rates as well as low growth of retail and commercial real estate. If such risk factors are realized, we will likely see muted returns for REITs resulting in significant opportunity cost. Concluding Summary  While REIT ETFs such as USRT offer low expense ratios and attractive dividend yields, I believe the exuberance for REITs is slightly overblown. Proponents for REIT investment point towards a “normalization” of low interest rates, real estate and economic growth, and the benefits of REIT stock ownership. However, I believe these benefits are a bit overhyped. While I personally do invest a small percentage in REITs, I am not as enthusiastic about the outlook for REITs. I also believe there is risk of opportunity cost compared to broad-based S&P 500 or total market funds. I therefore consider USRT and comparable REIT ETFs a hold for now.","kind":null,"is_publish_news":null,"is_publish_highlight":null,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.22.5","shortVersion":"4.22.5","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2435630283"}