REIT ETFs Prepare For Real Estate Sector Separation

When it comes to real estate stocks and the corresponding exchange-traded funds, income investors primarily focus on the yields being lobbed off by these securities and what the Federal Reserve is up to. Why? Because real estate equities are believed to be negatively correlated to rising interest rates.

Investors should also remember that in September, real estate becomes the eleventh member of the Global Industry Classification Standard (GICS) group. Real estate stocks and real estate investment trusts (REITs) are currently part of the financial services sector. Based on current dividend yield data, only the telecom and utilities sectors would sport higher yields than real estate if real estate was its own sector right now.

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With Treasury yields slumping this year and new conventional wisdom dictating that the Fed will not raise interest rates any more than twice this year, investors have been pouring into some REIT ETFs. For example, the Vanguard REIT Index Fund VNQ, the largest real estate ETF, has added $1.83 billion in new assets this year, while the Schwab U.S. REIT ETF (Schwab Strategic Trust SCHH) has seen inflows of nearly $92 million.

Looking Toward VNQ And SCHH

“Funds from operations (FFO) growth in 2015 were strong for many REIT sub-industries, with 18 percent for residential REITS and 15 percent for office REITs. While Ken Leon, a REIT equity analyst for S&P Global Market Intelligence's Equity Research Services expects mid-to-upper single-digit FFO growth in 2016, he notes that there is ample capacity for dividend growth for many companies. Indeed some of these companies already raised their dividends in 2016,” said S&P Capital IQ in a note out Tuesday.

FFO is a key metric used by REIT analysts and investors to assess a company's ability to sustain and grown its distribution. REIT ETFs such as VNQ and SCHH, two of the lowest fee products in the category, faced a trying environment in 2015, as investors anticipated the Federal Reserve's first interest rate increase in nearly a decade, but that did not prevent many investors from searching for yield with REIT ETFs.

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VNQ and SCHH yield 4.2 percent and nearly 2.4 percent, respectively, on a trailing 12-month basis. Another low-fee option in the space is the Fidelity MSCI Real Estate Index ETF FREL, which has a trailing 12-month yield of 3.7 percent.

Focus On FREL

“FREL launched in 2015 and has a 0.12 percent expense ratio. The ETF has 203 holdings, more than VNQ’s 153. FREL’s exposure to specialized REITs (25 percent vs. 16 percent) is higher than VNQ’s, while its retail REIT exposure (20 percent vs. 25 percent) is lower. Both ETFs rank favorably to S&P Global Market Intelligence for the qualitative risk of its holdings,” said S&P Capital IQ.

Of the three ETFs highlighted here, VNQ is the top performer this year with a 4.3 percent gain.