A Real Estate ETF With Curb Appeal

Vanguard Real Estate ETF is one of the cheapest real estate funds available, with an expense ratio of 0.12%. It features experienced management and an excellent record of tracking its index. It is a fine option in its niche, earning a Morningstar Analyst Rating of Silver.
Until early February 2018, the fund tracked the MSCI US REIT Index, which holds domestic-equity REITs, or firms that manage properties and collect rent. That index doesn't include mortgage REITs, which invest in mortgages and mortgage-backed securities rather than actual properties, nor does it include non-real-estate specialty REITs, such as timber or cell-tower REITs.
In early February 2018, the exchange-traded fund began to migrate to a new benchmark: the MSCI US Investable Market Real Estate 25/50 Index. The index change came in response to recent changes to MSCI and S&P Dow Jones' Global Industry Classification System, or GICS, which carved out real estate as a stand-alone sector for the first time. The fund's new benchmark includes the aforementioned non-real-estate specialty REITs, which make up approximately 14% of VNQ's post-transition portfolio. This change made the portfolio more representative of the opportunity set available to its Morningstar Category peers and modestly increased its capacity as well. These attributes reinforce our positive view of its process.
Lead skipper Gerard O'Reilly has managed the mutual fund version of this strategy since its 1996 inception, and he also runs the $730 billion Vanguard Total Stock Market Index as well as numerous other big index funds. That experience has helped O'Reilly do an excellent job of tracking the ETF's benchmark and has helped it outpace most other real estate ETFs and mutual funds over time. Its 10-year return ranks in the top fourth of real estate funds.
VNQ's low 0.12% expense ratio gives it a durable edge. The only funds in the real estate category with lower costs are Schwab U.S. REIT ETF, Fidelity MSCI Real Estate ETF, and iShares Core U.S. REIT. All in all, there's plenty to like here.
Fundamental View
Since the global financial crisis, REITs have benefited from two important dynamics. Interest rates have remained low, and, with slow and steady growth in the broader economy, developers have not roared back with a massive influx of new supply in the marketplace. As a result, incremental demand from a slowly improving economy has accrued to existing landlords in the form of higher occupancies, higher rental rates, and solid same-store net operating income growth. REITs also have used low rates to refinance existing debt, and property valuations have risen. In some respects, the past 10 years have offered a perfect positive storm for REITs.
Interest rates have ticked up recently and may rise further. Higher interest rates remain the REIT sector's greatest potential headwind. As rates rise, REITs' interest payments go up, which means REITs have less cash flow available for dividends for equity investors. As a result, higher rates mean greater interest expense. Not surprisingly, REITs with lots of debt and higher levels of near-term maturities--which would need to be refinanced--will fare worse than REITs with less debt and long-dated maturity schedules. Nonetheless, REITs with relatively modest levels of leverage and low debt service relative to cash flows generally should fare better in a rising-rate environment.
While higher interest rates would affect all REITs, industry subsectors would be affected differently, depending on lease durations. REITs with shorter lease durations likely would fare relatively better in a rising-rate environment because they would be able to more frequently seek higher rents from tenants as rates rise (especially if it is due to inflation) than could REITs with longer lease durations. And higher rents could somewhat offset the negative impact of higher interest expense. Among REITs, hotels generally have the shortest lease durations, followed by multifamily properties. After that, from short to long, the other subsectors are self-storage, industrials, retail, office, and healthcare. This fund has significant exposure to the REITs that would be expected to get hit hardest, such as healthcare, office, and retail, and it holds fewer REITs with the shortest lease durations.
Rising rates don't happen in a vacuum. REITs are cyclical businesses, and rates frequently increase when the economy is strong. What investors should fear most is the prospect of REITs getting hurt by rising rates but then not being helped by a corresponding lift in the economy driving occupancy and rate increases on tenants.
Portfolio Construction
Beginning in February 2018, the fund began to migrate from its prior bogy, the MSCI US REIT Index, to its new benchmark, the MSCI US Investable Market Real Estate 25/50 Index. The new index is a broader representation of the real estate sector and thus, the opportunity set available to category peers. Per MSCI data, the aggregate market capitalization represented by this new target is approximately $200 billion greater that its prior index. The most notable additions to the portfolio will be non-real-estate specialty REITs. These REITs account for about 32% of the value of the fund's new benchmark, versus 19% for its former index. American Tower, Crown Castle, Welltower, and Weyerhaeuser are four such new names that appear on the fund's roster of top 15 holdings. This will likely increase the fund's risk profile. All told, we view this index change favorably and reaffirm our Positive Process Pillar rating. The fund's new benchmark index is reviewed semiannually and rebalanced quarterly. Its portfolio is diversified across property sectors. This is a good benchmark for core real estate exposure, and the managers have done a good job of tracking their index closely. There's no reason to believe that this will change as the fund transitions to its new benchmark.
Fees
This ETF charges 0.12%, which is significantly less than the fees almost all its competitors charge. VNQ earns a Positive Price Pillar rating. When possible, REITs should generally be held in a tax-deferred account. Most of their dividends are taxed as ordinary income and don't benefit from the low 15% qualified dividend rate. The unfavorable tax treatment arises from the REIT legal structure, which, in exchange for no taxation at the company level, obliges the firms to pass on the vast majority of their earnings to shareholders.
Alternatives
Only Schwab U.S. REIT SCHH, Fidelity MSCI Real Estate FREL, and iShares Core U.S. REIT USRT can challenge VNQ's low price. They charge just 0.07%, 0.08%, and 0.08%, respectively, for very similar portfolios. The Schwab ETF tracks the Dow Jones U.S. Select REIT Index, the Fidelity ETF tracks the MSCI USA IMI Real Estate Index, and the iShares ETF tracks the FTSE Nareit Equity REITs Index. All are fine alternatives to this ETF, though FREL is VNQ's closest competitor.
SPDR Dow Jones REIT ETF, which charges 0.25%, tracks the same index as SCHH but charges fully 18 basis points more. While RWR has tracked its index closely, its performance lags that of SCHH by the difference in their expense ratios, and the difference in liquidity between the two ETFs is minimal. As a result, investors interested in RWR should take a close look at SCHH.
IShares U.S. Real Estate is the only large REIT ETF whose index allows it to include all REITs. Most indexes exclude REITs that derive the majority of their income from non-real-estate activities, a category that contains mortgage, prison, and timber REITs. IYR includes these REITs. IYR is expensive with a 0.43% expense ratio. With inexpensive alternatives to choose from, this fee is difficult to justify.
IShares Cohen & Steers REIT only tracks the 30 largest REITs. It costs 0.34% a year. IQ U.S. Real Estate Small Cap ETF offers exposure to the small-cap segment of the market for 0.70% a year. Pure mortgage REIT exposure is available through iShares Mortgage Real Estate Capped ETF, which charges a 0.48% expense ratio.
Ben Johnson, CFA does not own shares in any of the securities mentioned above.

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