VNQ And The Interest Rate Panic
Summary The biggest drawback of VNQ compared to some other equity REIT investments is its lower yield. One common argument I hear is that investors should wait for higher yields on the bond market to push share prices down. I don’t see small changes in interest rates hurting the fundamental operations of equity REITs. When rates on MBS go up, it makes houses less affordable. For tenants, that means renting for a longer period. Materially higher rates could have a small direct negative impact on equity REITs that are rolling into new debt financing for their properties. When I talk to people about REIT ETFs, the most common thing I hear is: “I’m planning to buy some shares; I’m just waiting until interest rates go up so I can get a better deal”. The good news about that response is that it shows investors are being prudent about their risk and expected return. When investors become irrational and assume the market will only go up, I become concerned that euphoria has taken hold and that there will be too many purchases without enough reasoning. One of my favorite REIT investments is the Vanguard REIT Index ETF (NYSEARCA: VNQ ). I believe VNQ or a very similar fund should be a core part of an investor’s retirement portfolio. Specifically, I like REIT ETFs as an investment tool for tax-advantaged accounts or for investors in very low income tax brackets. Due to the extensive diversification provided by VNQ, I believe it offers better risk-adjusted returns than individual equity REITs. I back this theory up with my own money, and hold a material portion of my retirement accounts in VNQ. The best argument against VNQ There is one major argument against VNQ, and it deserves recognition. The yield on the ETF is “only” 3.87%. Many REIT investors are investing in REITs primarily for income, not for growth, and the level of dividend yield is a very important consideration. While I do advocate using total return as the primary measure of performance, I like to see investors considering yields on equity investments as another important measure. I want them to look at yields, because it reminds them that when prices go down, the investment becomes more attractive. When the prices are soaring, the investment is less attractive. In many parts of the market, investors lose track of those fundamentals. In REIT investing, it is more common for investors to watch the yields. When investors choose not to buy into VNQ, one of the other top options is Realty Income Corporation (NYSE: O ). It offers a solid yield, currently over 4.7%, and a market cap over $10 billion, which is good for liquidity. If an investor wants to focus on yield and make a larger investment in Realty Income Corporation, I would encourage diversification – I can appreciate the emphasis on yields. The argument that I don’t trust Many investors are concerned that rising interest rates will mean poor performance across the equity REIT industry. I don’t think we should expect to see incredible returns, but I do expect a fairly solid performance. When interest rates go up, income investors will have more alternatives for investments that generate respectable levels of income. Since we are still dealing with supply and demand, a reduction in the demand for REITs should indicate that VNQ would either need higher dividends or a lower share price to encourage investment when investors are deciding between VNQ and bonds. The issue that investors are ignoring is that many equity REITs stand to profit from increasing interest rates. There is very little discussion about the economic impacts of the underlying businesses. People focus solely on the supply and demand for shares in the REITs, rather than how those businesses will perform. When short-term interest rates go up, long-term rates should also go up on MBS. I’m fairly confident about that – my primary area of focus as an analyst is the mREIT industry. I’ve been watching and analyzing the fluctuations across the yield curve over the last year. Higher short-term rates mean mREITs need to acquire higher yields on new securities to make up for paying higher rates on their repos (repurchase agreements). If the new MBS don’t offer higher yields, the mREIT has no good reason to purchase them (the MBS), because they would need to finance the purchase with repurchase agreements. When the interest rates on MBS increase, the cost of home ownership also increases. If the interest rate on mortgages increases, the same couple that could qualify for a loan before may be unable to qualify for the loan (assuming the same total loan value) after the interest rate increase. This is a factor that can keep more people renting apartments and drives up the performance of apartment REITs. Remember that it isn’t just share prices that are set by supply and demand; rent prices are set the same way. Increased competition from financially stable renters that are unable to get mortgages because of high interest rates would be a favorable development for the owners of the apartment building. Leverage It is true that many REITs using some debt financing; however, extensive leverage is rarely seen outside of the mREITs sector. The levels of leverage are frequently fairly low, and the length of the loans is fairly short. If interest rates become unattractive, many equity REITs will be able to exit the market for debt financing, or at least, reduce their use. I doubt we will see interest rates become that unattractive, but a reduction in the attractiveness of debt may also encourage a reduction in the development of new properties. If equity REITs spend less on developing properties, they will be reducing the future supply of apartment buildings. While REITs are required to make distributions based on their income, the level of “income” they report is often significantly different from their FFO (funds from operations). Many analysts view FFO as a better measure for estimating the amount of dividends that could be sustainably distributed. While FFO isn’t perfect, it does the job reasonably well. Income under FFO that is not income under GAAP can be reinvested in new properties. A reduction in the growth rate of properties would imply that REITs should be paying out more of their income and making less investment in future capacity. On the other hand, if they really find short-term debt financing unattractive, they can take the opportunity to pay down some debt, rather than raise dividends immediately. I don’t expect to see short-term yields become high enough to make using some debt financing unattractive for most equity REITs, but I have been watching MBS rates increase materially. Other Equity REITs Not all equity REITs are invested in apartments, and VNQ is offering a fairly diversified portfolio. However, the method of financing physical property remains a critical concern for customers of the equity REITs. Even stores that need a physical place to operate will be required to determine if they will buy or rent the property, and increases in MBS rates should create some similar problems for the corporate customer as it does for the couple renting and wishing to buy a home. Conclusion Since I’m considering total return, an increase in income offset by a decrease in growth is a wash. I simply see an attractive segment of the market that is somewhat out of favor because investors are waiting to see higher yields. I see a compelling long-term investment opportunity here, so I’ll keep investing and view temporary weakness in share prices as an opportunity to get more shares for the same amount of cash. Disclosure: I am/we are long VNQ. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.