VNQ ETF: To REIT Or Not To REIT

Summary

Real Estate can be a great business, REITs make it simpler and more diversified and an ETF of REITS even more diversified. However, are REIT ETFs superior long-term investments? The last 20 years of performance data suggest they are not. I took an in-depth look at Vanguard Real Estate Index Fund ETF (NYSEARCA:VNQ) and came away disappointed.

Real Estate Investment Trusts also known as REITs are investment companies that own and lease/rent real estate of all kinds, from offices, hospitals, distribution centers, cell towers, and data centers to name a few. The REITs can actively manage or outsource the administration of their assets, have debt limits, and most importantly are required to distribute 90% of net income in dividends to avoid taxes. The high payout and limited leverage imply lower growth, the REIT does not have ample resources to buy or develop new real estate assets without new capital i.e., a capital increase (issuing new shares), which dents growth compounding potential. Despite the limitations, REITs are a concept that is appealing to many investors.

Performance

The market looks at REITs as bond proxies which means that prices move inverse of Fed Funds and US Treasuries. This explains the negative returns in the last two years. The end of rate hikes and the start of an easing cycle should provide a valuation boost.

I compared the pure price and total return performance of VNQ with some of the larger sector peers and the S&P 500 (SPX) and found that the VNQ did not distinguish itself from peers and vastly underperformed the SPX. In addition, the current dividend yield of the SPDR Portfolio S&P 500 High Dividend (SPYD) is almost 100bp above the VNQ. It seems real estate within a REIT ETF may not be as rewarding as investing in the SPX.

The SPX represented by the SPY nearly doubled the total return of VNQ in all time frames

Portfolio Overview

The VNQ has over 150 REITs in its portfolio, however, despite its size and apparent breadth, the ETF concentrates 50% of assets in 13 REITS. VNQ’s size, US$64bn in AUM, is larger than all but three REITs, which may make diversification more difficult. I gathered consensus estimates on 40 holdings that represent the top 80% of AUM. The consensus price target points to a weighted upside potential of 7% for 2024 plus a 3% dividend yield may provide a total return of 10%. I also calculated the dividend payout vs FFO at 50%. This means the REITs can add assets with accumulated cash flow.

FFO Growth

The growth of FFO (funds from operations or cash earnings) is the primary metric that the market utilizes to gauge the health and performance of a REIT along with occupancy, lease rates, Cap Rate, and ROE. Using consensus estimates I calculated a 5% average growth rate for the YE24-25 period. The market estimates FFO will accelerate from a 2% level in 2023, which is partly driven by lower debt costs and perhaps higher occupancy and lease rates. This is not a growth portfolio.

Dividend Growth

Another key price drivers are dividends, the higher the better, and when and if Fed Funds decline REITs should gain. However, it seems that dividend growth is more challenging than FFO growth. Consensus estimates point to 4% DPS growth, below the 5% FFO increase. This means that dividend yield may be relatively flat at 3% for the next two years. This yield is lower than many dividend-focused funds I have covered such as the Virtus InfraCap U.S. Preferred Stock ETF (PFFA) or Cohen & Steers Quality Income Realty Fund (RQI).

Valuation

Many REITs are valued using a P/FFO multiple. The consensus has a target P/FFO of 17.5x, which compares poorly with FFO growth of 5%. Adopting relative valuation metrics such as PEG (PE/EPS Growth) to P/FFO Growth generates a PEG ratio of over 3x, not cheap in my view. However, most REIT assets have been quite resilient to macro volatility, that was until the pandemic exasperated changing consumer, and worker habits i.e., e-commerce and remote work as well as the sharing economy. Real Estate has developed into a riskier business than in the past, which may require a rethink on valuation.

Conclusion

I rate VNQ a sell. The REIT ETF does not provide superior dividends than the broader market or more specialized yielding strategies, while the “safe” label has been challenged due to changing habits prompted by technology. There are REIT sectors such as data or distribution centers that buck the trend, but they are diluted in an ETF portfolio. Dividend or income investors may be better rewarded with other strategies or asset classes in my view.