Where Real Estate Is Rocking Again: REIT ETFs

Amid all the whining about residential and commercial real estate markets, exchange-traded funds (ETFs) comprising real estate investment trusts (REITs) have quietly been kicking butt.

"REIT ETFs are leading the S&P by a healthy margin, outperforming the S&P over the last 12 months," says Timothy Strauts, an ETF analyst for Morningstar, who covers REIT ETFs.

The category, U.S. ETF Real Estate was up 22% year-to-date through Sept. 21, compared to 3.71% for the the S&P 500 stock index, according to Morningstar. Last week, Vanguard REIT ETF (VNQ) traded near a new 52-week high of $54.85.

"REIT ETFs and REIT mutual funds have put together a remarkable track record on both a year-to-date and one-year basis," says Mark Ward, chairman of the Investment Policy Committee at Lucien, Stirling & Gray Advisory Group.

The Attractions of REITs

Wondering what a REIT is? It's a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages. REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate.

Among other things, REITs invest in shopping malls, office buildings, apartments, warehouses and hotels. Some REITs will invest specifically in one area of real estate -- shopping malls, for example -- or in one specific region, state or country. Investing in REITs is a liquid, dividend-paying means of participating in the real estate market.

Why are they attractive? "Tax efficiency, liquidity, compound interest. If you don't have $140,000 to buy that condo and start renting it out, you can find a REIT ETF starting probably at $50," says Ty Young, president of wealth management firm Ty J. Young. They also provide a "short" option for investors. And their requirement to spend 95% of revenue as a dividend, is another attraction. "With a lot of cash on hand, they represent a strong investment vehicle," Young adds.

Back From the Abyss

During the financial crisis real estate went through a severe devaluation, and real estate ETFs felt the pain. "Most REIT ETFs lost more than 60% of their value during this period," says Jeffrey Rogers, president and chief operating officer of Integra Realty Resources. As the U.S. economy has improved, real estate values have stopped their free fall and are close to equilibrium, says Rogers. As these underlying commercial real estate securities began to recover, so did the REIT ETFs.

So, the fact that REIT ETFs are faring so well isn't surprising to some, "given what transpired over the last three years and the now-known root causes of this financial upset," says Ward. "It appears on the surface that since the underlying cause of this crash came from real esate, a mirror recovery in REITs came a little later as investors waited a little longer to tiptoe back into them, as it wasn't apparent to the usually more conservative REIT investor that the recession was ending."

He adds: "Now that it is clear that while things are still tough all over, the worst-case scenario has yet to pan out, causing the markets to bid the prices on securities and REITs back to more reasonable levels."

Hardly Risk-Free

Once investors realized the world wasn't ending, those looking for higher income sought out REITs, explains Morningstar's Strauts, who adds that REIT ETFs are paying about 3.5% yields, compared to around 1.7% from companies in the S&P 500.

A few years back, REITs had a lot of debt on their books, and when the credit crunch happened, they weren't able to refinance. But as the credit markets opened up again, they've been able to refinance at favorable terms, which helped strengthen them, says Strauts. They've also been raising cash.

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Despite REITs' recent standout performance, however, they're not without risks. "The biggest risk with REITs is always going to be the stability of the underlying rents on the properties owned by the trusts. So long as those renters continue to pay their rents and someone is always in line to take on or renew the leases as they expire, then the REITs should remain stable," explains Ward of Lucien, Stirling & Gray. "However, if the commercial side of the market begins to weaken, then that should over time begin to weaken the yields further, to the point that shareholders no longer find value and sell their shares."

Then too, says Strauts, "If the economy moves to a double dip, then real estate will dip. But if the economy trudges along, then real estate will be OK."

In a recent article on TheStreet.com, Don Dion summed up the market for investors: "While I feel particularly more optimistic toward REITs, I expect choppy performance to come from all areas of the real estate market. Therefore, investors should prepare themselves for the possibility of seeing swings both lower and higher as we continue along the road to recovery."