3 REIT ETFs: A Call On A Rate Cut Next Year

A call on rate cuts

REITs are beaten down. Would I consider them an anti-bubble absolute steal at the moment? Probably not. But collectively down nearly 30%, Using The Vanguard Real Estate Index Fund ETF (VNQ) as a proxy for the REIT market, it sits in clear bear territory.

There are only a couple of single-name REITs I like at the moment, but as a group, the entry point might have enough potential future alpha in the tank to beat the market in the next decade going forward. I am going to lay out some points in my theses as to why I believe rates will retreat next year and why REITs collectively are set up to feast in the wake or property discounts in the quarters to come.

The US government can't stand these rates

I've read the Big Short book and watched the film. This was a rare instance where I believe the film was able to bring out some visualizations that the book didn't. I love the part of the film where the Steve Eisman character, re-named Mark Baum in the movie and played by Steve Carrell, gets a chance to visit with some of the BBB and BB-rated subprime mortgage brokers.

To paint the picture, first, the brokers laugh about purposely looking for bad FICO score borrowers to increase their yield. They don't care because some big bank buys the loan in a few days, bundles them up with a bunch of other bad mortgages and sells them off in a CDO. He then visits one of the mortgage broker's clients, the exotic dancer who promptly tells him that she has 5 houses. She goes nuts when Mark Baum tells her "your adjustable rates are about to reset to market. Those mortgage brokers lied to you when they said it wouldn't happen."

He darts off and says.. short the residential mortgage market!

How to short the government

The past few years have been like a long string of stories where Capitol Hill has been caught up in one blunder after another. Partisanship aside, it feels a lot like Mark Baum's scene in the Big Short. How did some of these people get here? Can they manage these new interest payments or even realize some of the debt payments are about to quadruple or quintuple? How do we short them?

You can't as long as the Federal Government doesn't have to run a balanced budget. However, the high-interest rates the FED have instituted has left the government with the inability to do what it always likes to do most, expand. They are essentially the exotic dancers finding out that all their debt is the adjustable rate type and about to reset. Let's see just how dramatic the government "arm" loan increases actually are.

The 10 year is bad but not as bad as the 2 Year Treasury parabola.

During Covid, the yield curve had not yet inverted and the 2 and 5 were still yielding less than the 10. A lot of two-year, 2021 sub 1% debt is now going to have to be rolled into 5+%. Most of this never gets paid just rolled over.

The solution

1. Print
2. Shrink the government
3. Yell at Jerome Powell to lower the rates

The first will happen. I give the second a near-zero possibility and the third near 100% chance once the next election is in the bag for whichever party wins. In the interim, the ruling party is in a pickle to lower inflation to get votes while not being able to expand as quickly as they like due to massive interest payments.

Once the next election is over and votes are no longer important, I would bet my bottom dollar whomever the President is prioritizes rates being lowered. Not for our benefit but for theirs. Luckily unlike our exotic dancer friend, the borrower in this instance also hires the CEO of the bank they borrow from.

How to take advantage?

Well, firstly ask yourself what is the most interest rate-sensitive sector in the economy? What is the one thing even Dave Ramsey advises you to take out "good debt" on? Real Estate of course. Buying broad-based REIT ETFs de-risks any bets on single REITs and spreads your bets across all real estate sectors. Yes, some will fail in light of these rate hikes, but others will prosper and grow even more rapidly than before when rates revert.

VNQ

The top funds to consider

Ed Thorp, famed mathematician, Billionaire, and Warren Buffett contemporary once ran a very successful options trading hedge fund, but in the long run, he found that low-cost indexing beats most strategies most of the time. He said to never pay more than 0.2% expense ratio for any index fund to make sure the fee doesn't eat into the performance. That's our starting position to make sure that expense ratios are not dampening our total return over time. The above three all fit that bill and hold the core of the most important REITs comprising the U.S. economy.

On a three-year total return basis, we can see the returns are rather paltry when compared to the S&P500. As real estate services every single sector in our economy, I view REITs almost as a microcosm of the economy and diversified in their own right as long as a fund holds nearly every sector type.

Let's take a look at the holdings of the three funds:

VNQ

Index the fund follows: MSCI US IM Real Estate 25/50 Index

XLRE

Index the fund follows: Standard & Poor’s 500 Composite Stock^® Index (“S&P 500^®”) Real Estate Sector

USRT

Index the fund follows: NAREIT equity REITS index

Many commonalities and overlaps

The three funds are heavy Prologis (PLD) at the top. VNQ is unique in that the fund doubles up on holdings 2-9 by holding the admiral share mutual fund version as their top holding. This essentially would add another 12.67% X 7.75%= .98%, or roughly 1% extra in holding concentration to their Prologis position. The heavy current weighting by all the REITs is showing a defensive stance as logistics centers are being assumed the most resilient real estate asset classes.

That being said

iShares U.S. Core REIT ETF (USRT), has a slightly different blend of holdings. This ETF follows an index comprised by the National Association of Real Estate Investment Trusts or NAREIT. With the addition in the top holdings of VICI Properties Inc. (VICI), Extra Space (EXR), and AvalonBay Communities (AVB) being different from VNQ or XLRE, a 2-fund purchase of either VNQ and USRT or XLRE and USRT could get you the widest diversification considering the top 50% concentrations of those portfolios. USRT in this instance seems to have a more bullish call on residential rental communities, casinos, and storage.

The yields

For the yield lovers out there, and I'm guilty as charged, VNQ has a nearly 1% advantage in this comparison. VNQ leads the 3-year dividend CAGR but is edged out by XLRE on a 5-year basis. With the REIT industry seeing some dividend cuts, these yields could have a slowing growth rate in years ahead. That being said, the dividend can be your friend in this instance.

Big dividends can be your friend in a bear cave

VNQ and other REIT index funds are some of the biggest historical dividend yields you'll find outside of energy or utilities. I always hold my stocks on DRIP and never take dividends in cash payments. The accretive nature of your dividends will force you to dollar cost average down when you don't have the stomach for it. VNQ has a big accretion machine working for it.

Bear case

Let's say for instance the next decade ahead is rough, real rough. In this case, it takes VNQ a whole decade to get back to the all-time high. The CAGR over 10 years from $80 to $116 is 3.75% per year. Adding in the maintaining of the dividend of 4.68% at only the 10-year dividend CAGR of 4.27% we get the following (not incorporating taxes):

A 155% total return on DRIP for the next decade is not too bad at all. Maybe not market beating, maybe so, but pretty good for an estimated bear case.

Bull case

Rates get cut in 2024 and this revisits the all-time high in 2024 and then grows at 4% per annum thereafter (roughly inflation plus) for 9 years to 2033, all the while growing the dividend at the 10 YR CAGR rate. This scenario would get us to a price of $158.75 on year 10. Taking this into consideration along with the dividend we have the following:

In this assumption, which I still believe is realistic, we have a potential market beating return at this entry point on REIT ETFs. The market could return more than this, but this return over the next decade would make for a great probability of winning the total return race.

REITs have capital sourcing advantages

Having been in Real Estate finance and sales all of my adult working career, I am aware that REITs have several advantages over private and publicly listed property owners and developers.

REITs can issue equity, preferred equity, private equity, bonds, credit revolvers, and OP shares in an UPREIT format. OP shares through UPREIT umbrella formations allow some 1031 exchange loopholes to bring in even more capital from private real estate owners wanting to avoid taxes. Capital sourcing is the lifeblood of any real estate investor.

When we go through this CRE shakeup, with many commercial loans coming due in 2024, the best REIT operators can pounce. Physical real estate is the best example of an entry point beating other investments. Since it is such a capital-intensive business, having more access to capital than others allows for a few amazing once or twice-in-a-lifetime opportunities to buy valuable assets at fire sale prices.

Down but not out

The REIT sector is underperforming in anticipation of a big shakeout. I am betting that the government will lower rates for their own sake in the not-too-distant future. This will catapult VNQ and other REITs back up near their highs. The entry point between now and the time that our government realizes they have a massive adjustable rate mortgage on their hands is a good period for dollar cost averaging some of your funds into diversified REIT plays.

Buy till the fear is gone and then move on

In summary, the key here is to buy while the fear remains and then move on. There are many important sectors in the economy and no one sector is the go-to forever. On the flip side, there are almost no sectors that are to be avoided forever. Everything is cyclical.

I've personally begun to switch my REIT buying from single names to a more broad based approach. All three of these funds will get you an excellent slice of the Universe of available commercial real estate. This is my current approach in predicting a call on rate cuts in 2024. I'm happy to dollar cost average the entire commercial real estate sector.