RIET: It's Too Early To Tell Where This Is Going

RIET Hoya Capital High Dividend Yield ETF (NYSEARCA:RIET) is a high-yield fund that focuses specifically on REITs. The fund invests in all 14 subsectors of REITs including but not limited to residential, healthcare, commercial, malls, data center, office, specialty, retail and storage. The fund has been around for less than 2 years and its goal is to have a dividend yield around 8-10% in the long run. A little less than half of this yield is expected to come from dividends received by the fund and the rest is expected to come from either capital appreciation or return of capital.

The fund offers monthly dividend payments that roughly equal to 0.75% of its NAV. In the last 12 months the fund paid a total of $1.01 in dividends which corresponds to 9.6% in dividend yield. Meanwhile, the fund's share price dropped about 15% during this time. Since inception, RIET saw its share price drop by -31% while its total return (after reinvestment of dividends) totaled -21%.

This might sound like a terrible performance, but we have to add context to it. Since late 2021 REIT indices (both American and global) had one of their worst performances in a long time. Many people consider real estate and REITs as a great inflation hedge and in the long term they are but in the short term they were one of the worst assets to hold in the last couple years. To be fair, this underperformance was probably not because of inflation, but likely because of the Fed's reaction to the inflation which included tightening money supplies and hiking rates. While inflation itself can be good for real estate prices, the fight against inflation is not.

A higher rate environment hits REIT valuations three ways. First, they make bonds more attractive in comparison so income-oriented investors sell their REITs and buy bonds instead. Today the average REIT yields about 3.9% while the risk-free treasury yield is 5.25%. Thus risk aversive investors had the motivation to switch to bonds since last year. Some investors even switched from holding common REIT shares to preferred REIT shares or bonds issued by the same REITs which provide much higher yields as compared to their common stocks.

Second, the high rate environment hurts REIT valuations because many REITs are leveraged and they use debt to finance their growth. When rates are higher, it makes it difficult and more expensive for REITs to roll their debt and their net income drops. This also curbs their growth rate significantly since there is less capital available to spend on purchases. In the long run we will likely see well capitalized REITs going on a shopping spree and buying less capitalized ones but in the short term, there will be significantly less acquisition activity both in terms of acquiring whole companies and acquiring real estate assets.

Third, when rates are higher, investors also have less incentive to use leverage (such as margins) so they are unlikely to purchase REITs or other relatively volatile income generating assets. We are also seeing a general slowdown in real estate purchases across the board due to high cost of capital.

I still find it interesting that REITs are one of the few sectors that actually seems to price in troubles of the economy though. When you look at many other sectors (especially technology, communications and consumer staples), stock prices have been rallying so hard that one would think that the economy is in perfect shape and interest rates are back to 0%. Many sectors of the stock market have been largely ignoring troubles of the economy and Fed's rate hikes lately while REITs have been taking a notice and getting repriced accordingly. This is probably why we are seeing a divergence between stock performance of REITs and other sectors.

I am not saying that REITs shouldn't have sold off because it makes sense for them to sell off in this environment but it also makes sense for other sectors to sell off, yet stocks in many other sectors act like they live in a different world. This most likely created a unique opportunity for REIT investors though because historically speaking the best time to buy stocks in a sector is when there is panic and everyone is avoiding that sector. No sector stays in a bear market forever and buying a sector during a bear market usually results in outsized gains in the long run.

RIET uses an interesting approach in its stock selection and diversification. The fund is invested in exactly 100 stocks and these stocks belong to 5 categories. This categorization is totally intentional. The first category is Dividend Champions. These are REITs with a history of hiking dividends for at least 25 years in a row. You'd be surprised to find out how few REITs actually fall into this category even though REITs are famous for their dividend histories. RIET has roughly 10 stocks in this category making up 15% of the fund's total weight. As per the fund's policy, no single position shall account for more than 1.5% of its total weight.

Next, the fund has 10 large-cap REITs, 25 mid-cap REITs and 25 small-cap REITs. Large caps make up 15% of the fund's total weight due to the rule mentioned above and mid-caps and small-caps each account for 30% of the fund's total weight. The last 10% of the fund's weight is allocated to 30 preferred stocks. Interestingly enough, the fund's rules also ban it from putting more than 0.33% of its total weight into each preferred stock. Together these make up 100 stocks and 100% of the fund's weight. While the fund is actively managed and its exact holding of stocks can change from quarter to quarter, this weighting scheme is not going to change and this will actually remain as the playbook of the fund's managers.

Will this type of arrangement result in outperformance? It's too soon to tell yet since the fund has been around for less than 2 years and most of this time was during a bear market for the REIT industry (which is still ongoing). One thing that I must add is that since its inception, this fund has slightly underperformed Vanguard REIT index (VNQ). If this underperformance continues, it might make more sense for investors to simply buy VNQ instead of RIET especially considering that RIET has an expense ratio of 0.50% while VNQ's expense ratio is a fraction of that at 0.12%. This might not sound like a huge difference but it will add up over time with compounding.

In conclusion, RIET seems like an interesting fund for income oriented investors. It hasn't been around for long enough for us to judge its performance and most of the fund's existence coincided with a bear market in REITs which is most likely still ongoing. If investors would still like to invest in this fund, I'd recommend starting out with a small position and perhaps reinvesting your dividends but not adding much more than that. If/when the bear market for REITs ends, this asset class is likely to have good returns but we don't know how much of those returns this fund will be able to take advantage of yet.