why-you-probably-shouldn8217t-buy-iyr

Why You Probably Shouldn’t Buy IYR

An ETF is a collection of securities — such as stocks — that tracks an underlying index. The best known example is the SPDR S&P 500 ETF (SPY), but there exists ETFs for almost every sector today, including REITs. They provide:

  • (1) Wide diversification
  • (2) Low cost
  • (3) And passive exposure to investors.

As one of the largest REIT ETFs, the iShares U.S Real Estate ETF (IYR) is often suggested as the preferred way to invest in REITs.

With this single ETF, investors can take care of all their REIT investment needs and be done with it. From a first look, it seems like an attractive vehicle for "know nothing" investors to gain broad exposure and earn passive income without all the hassle that comes with picking individual REITs.

So why aren't we buying it?

Reason #1 - We Want Real Estate, Not Technology

If you want to invest in a REIT ETF, it's probably because you want to invest in real estate to earn high income, enjoy inflation-protection and diversify your portfolio away from other sectors (including technology).

Yet, right when you look into the Top 5 holdings of IYR, you find three high-tech plays on data centers, cell towers and 5G. Literally half of the top holdings is allocated to high-tech investments:

IYR top holdings

source

I do not know about you, but when I invest in real estate, this is not what I have in mind. These are low yielding, richly valued, high growth investments that are very sensitive to technological shifts.

There's nothing wrong with investing in technology, but there's a big difference between buying an apartment community and investing in data centers or 5G. The latter resembles more a technology investment, rather than a traditional property investment, and this in itself already is a deal-breaker for us since we want real estate, not technology.

  • These high-tech REITs won't pay high income.
  • They won't provide the diversification benefits that we are seeking.
  • And finally, they won't provide the same protection against new technologies.

We love to invest in real estate because we are confident to say that a well-located apartment community will be greatly needed 50 years from now and likely worth much more than today. It's a technology-resilient investment and a great portfolio diversifier.

What about the data center? Will it still be around 50 years from now? Will the technology (and / or property layout and location) become obsolete by then? Maybe yes, maybe no - we do not know. This is not what we look for in a real estate investment.

Reason #2 - Overvalued Large Caps Dominate the Index

IYR is market-cap weighted, and therefore it will buy large-cap REITs in very large quantities without any regard to fundamentals or pricing. Right now, close to 40% of the fund is invested in the top 10 REITs - all large caps: American Tower (AMT), Simon Property (SPG), Crown Caste (CCI), Prologis (PLD), Equinix (EQIX), Public Storage (PSA), Welltower (WELL), Equity Residential (EQR), AvalonBay (AVB) and Digital Realty (DLR).

These are all high-quality companies, but they also are richly valued with little alpha-generation potential. We believe that this disproportionately-large allocation to large-cap REITs is especially dangerous today because the gap in valuation between small-cap REITs and large-cap REITs has rarely been this large: small cap reits outperform

source

While large caps trade at 20x FFO, small caps trade at just around 12x FFO - or a 40% discount to larger peers. Some of this premium is justified because large caps enjoy superior scale, lower risk, and better access to capital. However, we believe that a good portion of this premium is overvaluation that's caused by the capital flows of index funds into large caps.

We believe that it sets large-cap REITs (and IYR) for a less compelling risk-to-reward going forward. On one hand, they already are richly valued which limits further upside. And on the other hand, the capital flows of index funds are a double-edged sword that could hurt large caps in the next bear market.

Small-cap REITs appear to be better positioned with deep value and protection against the capital flows of index funds.

Reason #3 - 3% Yield is NOT Acceptable in Real Estate

A direct consequence of this high allocation to technology and large caps is that the dividend yield is a tiny 3%. For a real estate investment, this is not acceptable for us.

Real estate is supposed to provide high and consistent income within a portfolio. IYR fails to achieve this goal by investing its capital in richly-valued low-yielding REITs.

Even putting total returns aside, many investors would rather target a higher - yet sustainable - dividend yield for meeting passive income needs rather than simply targeting total returns.

Reason #4 - Similar Exposure, But Higher Fees

The largest REIT ETF is the Vanguard Real Estate ETF (VNQ) and so it's worth making a quick comparison here. Both ETFs are very similar. In fact, the Top 10 holdings are identical.

Yet, despite providing very similar exposure, IYR charges 3x higher fees than VNQ:

  • IYR expense ratio: 0.43%
  • VNQ expense ratio: 0.12%

0.43% may not sounds like much, but when you account for the long-term compounding, it can lead to massive differences over time.

There are reasons why VNQ is so much more popular and this is the main one. If you want to invest in a market cap weighted index, at least pick the cheapest one. How is IYR supposed to make up the difference here?

Reason #5 - Alpha Is Real and Abundant in the REIT Sector

ETFs make a lot of sense for most sectors because alpha is very difficult (impossible?) to achieve - leading to recurrent underperformance for most active investors.

However, this does not apply to the REIT sector. Active REIT investors have historically been able to consistently identify and exploit alpha-rich opportunities. The annual outperformance after fees has been 100-200 basis points per year, with the best investors reaching up to 22% per year compared to "just" ~10% for indexes:

Source

The reality is that the REIT sector remains particularly inefficient with frequent mispricings to this day. REITs still lack dedicated research specialists (relative to other sectors) and remain an obscure asset class to most generalist investors who are not experts in real estate.

A Better Approach to REIT Investing

Before we move on to present our approach to REIT investing, we want to make it clear that it's not suitable for everyone. We have access to superior resources, do this full time and have access to management teams because we represent more than 450 REIT investors at High Yield Landlord. (Disclosure: The objective of High Yield Landlord is to streamline this research process and allow interested members to emulate our strategy.)

Now with this disclosure out of the way, here's our approach to outperform REIT ETFs:

  • Overweight Small-Cap REITs: The average valuation is just 12x FFO, and by being selective, it's not unreasonable to find quality small caps valued at just around 10x cash flow. This massive discount relative to large caps (20x FFO) gives us a head start over ETFs such as IYR.
  • Save the Fees: The 0.43% annual fee is very expensive in the long run. By building the portfolio ourselves, we save a lot of money and improve our long-term performance.
  • Value Over Growth: We avoid overpaying for REITs by paying close attention to NAV. Many large caps such Realty Income (O) trade at up to 50% premiums to NAV, and we expect such lofty valuations to result in disappointing long-term results. We follow a value-approach and seek to buy REITs at a ~20% discount to estimated NAV - allowing us to control more real estate for each dollar invested.
  • High Immediate Income: We recognize that real estate is an income-driven investment first. We are NOT happy with a 3% dividend yield and target a sustainable 7%-8% dividend yield to generate high income while we wait for long-term appreciation. It also allows us to generate attractive total returns even in a flat market.

As of today, our Core Portfolio has a dividend yield of 7.2% with a comparable 68% payout ratio despite a yield that's more than double IYR. Beyond the dividends, the core holdings are trading substantially below intrinsic value at just 9.6x FFO - providing both margin of safety and capital appreciation potential:

High Yield Landlord

We do not claim to own the same "high tech" companies and may not enjoy the same growth prospects, but this is not what we are going for.

We are real estate investors who want to diversify and generate high income. Our portfolio gives us the feeling of being a "landlord" collecting monthly rent checks, rather than a stock market trader who speculates on future appreciation. IYR and its 3% yield is not sufficient to satisfy the needs of retirees and other income-driven investors.

With Better Information, You Get Better Results…

At High Yield Landlord, We spend 1000s of hours and well over $20,000 per year researching the small cap REIT market for the most profitable investment opportunities and share the results with you at a tiny fraction of the cost.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.