VNQ: The Most Attractive Sector On Our Radar (NYSEARCA:VNQ)

Thesis

I last wrote about the Vanguard Real Estate ETF (NYSEARCA:NYSEARCA:VNQ) back in August 2023 (see the next chart below). In that article, I argued for a buy thesis on the ticker based on its attractive yield spread relative to the risk-free rates (approximated by the 10-year treasury rates).

In this article, I will argue for an upgrade of my rating to a strong buy based on a few considerations. The first and most important consideration is that the fund is now the most attractively valued sector according to our dashboard (see the next chart below). If you are new to the dashboard, I have a quick tutorial in the next section and you can download it as a Google sheet to check out its inner workings following this link: Market Sector Dashboard.

Second, the fund just announced its March 2024 dividend, and the quarterly payout came in at $0.732 per share (excluding capital return, more on this later). This is a large increase from the payout a year ago (which was $0.57 per share). Thanks to such a large payout increase, the fund’s dividend yield on a TTM basis has increased by about 18% YOY, the largest YOY increase among all the sectors with the exception of the telecommunication sector (which increased a whopping 30% as seen in the chart).

In the remainder of this article, I will detail the impact of these changes and explain why it warrants a rating upgrade.

Quick introduction to our Dashboard and VNQ

Our dashboard has been detailed in our earlier articles. It is built around the concept of assessing different market sectors’ valuation relative to each other, to their own historical track record, and also to the risk-free rates. The specific metrics used are:

• The yield spread Z-score. It gauges the dividend yield of a given sector relative to the 10-year treasury rates. How the yield spread is calculated will be detailed in the next section. A larger Z-score suggests a larger undervaluation compared to the historical record and treasury rates. And vice versa.
• A Z-score that is closer to 1 means the yield spread is near the thickest level of the historical spectrum and is color-coded by bright green. And vice versa.
• The yield spread Z-score. Similar to the yield spread Z-score, it gauges the dividend yield of a given sector relative to its own historical record. A larger Z-score (greener) suggests a larger undervaluation compared to its own historical record. And vice versa.

Now, a quick introduction to the VNQ fund. The fund invests in REIT stocks. It holds a diversified portfolio of REIT companies that purchase a range of real estate properties such as office buildings, hotels, nursing facilities, telecommunication towers, etc. Its top holdings (see the chart below) clearly showcase the nature and diversity of its holdings. As seen, besides the Vanguard Real Estate II Index, the top 5 holdings include Prologis Inc. ((PLD), an industrial REIT), followed by American Tower Corp. ((AMT), a telecommunication tower REIT), Equinix Inc. ((EQIX), a data center REIT), Welltower Inc. ((WELL), a healthcare REIT).

Closer look at yield and valuation

As aforementioned, the fund has enjoyed a large increase in dividend payout YOY. Since REIT companies pay out most of their income as dividends, I think it is reasonable to interpret the improved dividends as a reflection of the improved fundamentals. I also believe VNQ’s price appreciation in the past year is not in tandem with such improved fundamentals. The following chart shows VNQ’s price change (normalized) in the past year. As you can see, the price of VNQ was up 7.76% only, far lagging the improvement in its fundamentals in my view.

Due to the mismatch of its price and fundamentals, the fund is now trading at a large discount – the largest in about a decade, in my view, judging by the dividend yield as shown in the next chart. This chart shows that VNQ’s average dividend yield is 3.10% in the past 10 years. Its dividend yield is currently around 4%, which is not only far higher than its historical average of 3.1% but also among the highest levels in at least 10 years, as seen. As just argued, I think dividend payouts are a good indication of a REIT company’s true economic earnings in the long term. If you agree with this argument, then its dividend yield serves as a good approximation of the owner’s earning yield. As such, the current yield suggests that the VNQ may be undervalued by a large margin compared to its historical track record (and our dashboard shows it is undervalued compared to other sectors too).

The role of capital return, other risks, and final thoughts

However, there is one caveat to all the data above. The chart below is a screenshot of the distribution statement from VNQ. As seen, the distribution includes both income and capital gains distributions. Return of capital (“ROC”) is a distribution of the funds’ capital to shareholders. In other words, ROC represents a return on the shareholders’ investment, rather than a profit. For REITs, ROC can come from the sale of assets or depreciation. Unfortunately, the data used above (and pretty all sources of dividend yield data you can find on the internet) include both dividends and ROC in the calculation of yield. This practice can make the dividend yield appear higher than it actually is. If the dividend includes ROC, the yield will be inflated. This can make the REIT appear to be a more attractive investment than it really is.

As such, careful investors should be aware of this distortion in their interpretation of the yield of VNQ (or other funds that include ROC in their distribution statement). The following chart shows my calculation of VNQ’s dividend yield in the past since 2013, with ROC excluded this time. As seen, the fund is currently yielding 3.19% without ROC on a TTM basis (instead of the 4% reported by most websites). And a 3.19% yield is still among the highest levels in a decade, almost one standard deviation above the average.

Other than this caveat, I assume most readers are familiar with other risks more generic to REITs (interest rate sensitivity, use of leverage, et al). So I won’t further dive into these discussions.

To conclude, the goal of this article is to upgrade VNQ’s rating to a strong buy. The upgrade is motivated by a few factors. The gist of my argument is that VNQ currently trades at the most attractive valuation levels compared to other sectors and its own historical track record due to a large mismatch in the development of its prices and earnings. The inclusion of return of capital in VNQ’s distributions could inflate the headline yield, but the yield is still among the most attractive levels in 10 years without it.