Futu Research | Investment Strategies of Real Estate Investment Trusts (REITs) in the Downturn

Views 20882024.05.29

In periods of volatility in financial markets, interest rate decisions by major central banks such as the Federal Reserve have become the driving force behind global asset allocations. The latest data show that the US quarterly unadjusted CPI rate stood at 3.4% in April, slightly down from 3.5% in January. Meanwhile, April core CPI month-on-month rate growth slowed to 0.3%, reaching its lowest level since December last year, marking the first significant cooling after three consecutive months of above-forecast growth. This data move not only reflects an easing of inflationary pressures, but also a new round of speculation on the prospects for a rate cut in the market.

Figure: Quarterly US Core CPI Ratio for the Last Year

Source: Macromicro
Source: Macromicro

Source: Macromicro

Against such a macroeconomic backdrop, real estate investment trusts (REITs) serve as an important bridge across the real estate and capital markets, and their investment value is increasingly prominent in an environment where interest rates are expected to decline. As Ralph L. Block, an investment expert at REITs, writes, “REITs prices increase with the increase in the cash flow and asset value of the property, making it ideal for investors seeking dividend income, stock price moderation and appreciation.” Therefore, at a time when the current rate decline is expected, it is important to delve into the investment strategies of REITs for portfolio construction.

First, what are REITs and how to price

REITs are a trust fund that distributes more than 90% of net after-tax income to investors by pooling investor funds, investing and managing real estate projects by professional institutions. In essence, REITs are a systematized arrangement of real estate investments.

The disadvantages of traditional real estate are large amounts of investment, lack of liquidity, difficult to materialize, high transaction tax charges, and REITs eliminate its disadvantages by retaining traditional real estate investments:

1. Regularly Mandate High Dividends: Currently, every country requires REITs to allocate at least 90% of their net income to investors each year, so that investors receive a continuous cash flow each year, generally quarterly or once every six months. However, it should be noted that specific distributions are still affected by the operating performance of REITs and volatility risks and are not guaranteed returns.

2. Smaller investments and higher liquidity: Real estate investment trusts have higher liquidity and lower investment amounts compared to direct investment real estate.

3. Lower transaction costs: Buying index REITs is cheaper than buying fund stocks compared to the high tax charges of investing directly in traditional real estate.

4. Specialized management: The management team of REITs are mostly professionals in the real estate field and are more sensitive to the development of the industry.

The pricing mechanism of REITs is a complex process that is not only influenced by the cash flow of the underlying asset, but also closely related to capital market demand, interest rate levels, real estate market cycles, investor expectations, and more. We focus on the creation and acquisition cycle of its cash flow:

1. Cash Flow Creation: REITs' main source of income is typically the rents generated by the real estate assets they hold and operate, stable tenancies and high occupancy rates mean more stable cash flow. At the same time, REITs can further increase cash flow by enhancing the value of an asset portfolio and effective management, such as renovating or developing new projects, applying financial leverage correctly, and controlling costs.

2. Acquisition Periods: The cash flow acquisition cycle of REITs is closely related to the characteristics of their underlying assets, ranging from a few months to decades, depending on the type of asset and the terms of the contract.

Second, the impact of falling interest rates on REITs

Specifically, REITs tend to become more attractive to investors when market interest rates are expected to fall. This is because the lower interest rate environment makes the dividend yield of REITs more attractive relative to other fixed income investments, thereby attracting more investors and driving up the market price of REITs.

As a result, falling interest rates often improve the market performance of REITs, increasing their investment attractiveness. When interest rate declines are expected or are already at the beginning of a drawdown cycle, it is often a good time to invest in REITs. As market sentiment towards the future builds, the prices of REITs have not fully reflected the full positive effects of a fall in interest rates, providing potential room for value growth.

3. How to invest in REITs

Investing in REITs and related ETFs is a stable and safe investment choice. It diversifies risk by combining multiple REITs, improves investment transparency and simplifies operations, giving investors one-click diversification of investments that are flexible to adapt to market changes that can be easily mastered by investment novices or old-timers.

Below, we will recommend several ETFs on the U.S. stock market and related to REITs that investors can choose from based on their investment preferences:

1. $Vanguard Real Estate ETF(VNQ.US)$: Tracks the MSCI US Investable Market Real Estate Index, which includes real estate stocks in the US investment market, covering a variety of REITs other than mortgage REITs, including office buildings, shopping malls, hotels and apartments. VNQ is one of the largest REIT-related ETFs on the market, offering broad exposure to the real estate industry with lower rates and better liquidity.

VNQ is known for delivering stable dividend returns. As of May 27, 2024/5/27, VNQ offered a dividend yield of 4.22% and assets of $325.56 billion. Its main constituents include several REITs related to AMBO, Public Storage Companies, Simon Properties, and more. At the same time, VNQ's management fee rate is around 0.08%, which is lower than its peers.

2. $Schwab Strategic Tr Us Reit Etf(SCHH.US)$: Tracks the Dow Jones U.S. Select REIT Index, which includes publicly traded REITs in the U.S. real estate market, representing the U.S. commercial real estate market, providing investors with returns related to direct U.S. real estate investments. SCHH offers investments in US REITs at lower rates, suitable for investors looking for cost benefits.

As of May 27, 2021, SCHH offered a dividend yield of 3.41% and assets of $63.85 billion. Its main constituents include several REIT-related trust companies such as Ambo, Welltower. At the same time, SCHH's management fee rate is around 0.07%, which has a better cost advantage in the industry.

3. $Real Estate Select Sector Spdr Fund (The)(XLRE.US)$: Tracks the Real Estate Select Industry Index, which includes companies engaged in real estate business in the S&P 500 Index, which is a real estate industry index separated from the S&P 500 Index and includes companies engaged in real estate development and direct real estate operations, primarily REIT-related trusts. XLRE IS ONE OF THE SELECT INDUSTRY SPDR SERIES WITH LOWER RISK.

As of May 27, 2024/5/27, XLRE offered a dividend yield of 3.57% and assets of $59.59 million. Major constituents include several REITs related to trusts such as Ambo, Simon Properties, and XLRE's management fee ratio was approximately 0.4%.

4th. $iShares US Real Estate ETF(IYR.US)$: Tracks the Dow Jones U.S. Real Estate Index, which reflects the overall performance of the U.S. real estate industry, including residential, commercial, and industrial real estate listed companies, as well as various REIT-related trust companies. IYR provides a broad range of investments in the U.S. real estate market, including residential, commercial, and industrial REITs.

As of May 27, 2024/27, IYR offered a dividend yield of 2.82% and assets of US$30.1 billion. The principal constituents include several REITs related to trust companies such as Ambo, American Electric Power, and Simon Real Estate. At the same time, IYR's management fee rate is about 0.42%, which is relatively high.

5. $Spdr Dj Wilshire Reit Etf(RWR.US)$: The tracking index and the SCHH are the Dow Jones U.S. Select REIT Index and represent the U.S. Public Traded REITs. Unlike SCHH, RWR's asset size is smaller and has lower liquidity compared to SCHH; however, RWR has an earlier time to market than SCHH, has higher market visibility, and the distribution of the positions of the two has some variation.

As of 2024/5/27, RWR offered a dividend yield of 3.90%, with assets of $14.24 billion and a management fee of 0.25%.

Risk Tips

REITs present attractive investment opportunities in anticipation of falling interest rates, but while seizing this opportunity, investors should understand and be alert to the risks involved. For example:

·REITs cannot guarantee investment returns and fluctuations such as market conditions, property policies, and economic cycles can affect rental rates and rents, thereby impacting fund income and potentially suffering significant capital losses.

· If the majority of REITs return from a limited number of assets and properties, prices will fluctuate dramatically due to changes in a single rental.

·REITs may use their capital to distribute dividends and may generate dividend actions such as dividends. This is a high requirement for the actual controller's ability and portfolio, so investors should consult the Fund's historical performance announcements and financial reports for information on the specific composition of dividends and changes in financing history. Avoid managers who have defects in some stores.

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Disclaimer: The above content does not constitute any act of financial product marketing, investment offer, or financial advice. Before making any investment decision, investors should consider the risk factors related to investment products based on their own circumstances and consult professional investment advisors where necessary.