2023-03-23 08:00:54 ET
Summary
- VNQ is a wildly popular low-cost REIT index fund.
- However, we believe that investors are setting themselves up for long-term disappointment with this fund.
- Instead, we share three high yield blue chip REITs that we think will provide much better returns.
The Vanguard Real Estate ETF ( VNQ ) is a wildly popular low-cost REIT index fund. However, we believe that investors are setting themselves up for long-term disappointment with this fund. In this article we share three high yield blue chip REITs that we think will provide much better returns than VNQ.
Why VNQ Is Poised To Disappoint
VNQ is very popular with retail investors due to its broad diversification, substantial liquidity (bringing with it tight bid-ask spreads), reasonably attractive 4% dividend yield, and low 0.12% expense ratio. This popularity is reflected in the fund's substantial $32.2 billion in assets under management.
Given that VNQ seeks to track the performance of the MSCI US Investable Market Real Estate 25/50 Index, investors in the fund get exposure to a broad swath of American commercial real estate with 170 total holdings. That said, the fund is market cap weighted, which means that the number of holdings leads investors to think that their investments are more diversified than they really are. In fact, nearly half of VNQ's portfolio is invested in its top 10 holdings :
VNQ Top Holdings (Seeking Alpha)
As you can see from the above, VNQ is primarily a bet on the very largest REITs in the United States, with only token exposure to the smaller REITs (where market inefficiency is most often found).
This is why we believe that VNQ is poised to disappoint. Investor dollars are being blindly poured into the very largest REITs, which tend to trade at premium valuations due to greater perceived safety, only pushing their valuation premiums higher. As a result, investors in VNQ are often effectively buying real estate at substantial premiums to private market value. This immediately makes it more difficult for these investments to deliver satisfactory returns over the long-term because when you overpay for an investment, your downside risk is amplified and your cash flow yield is immediately reduced.
Let's look at a few examples of this from among its largest holdings:
- Prologis ( PLD ) trades at a lofty ~25x AFFO and only offers a 3% dividend yield.
- American Tower ( AMT ) trades at 19.4x AFFO and only offers a 3.4% dividend yield.
- Equinix ( EQIX ) trades at 31.1x FFO and offers a meager 2.1% dividend yield.
- Public Storage ( PSA ) trades at 19.9x AFFO and offers a 4.2% dividend yield.
- Welltower ( WELL ) trades at 22.27x AFFO and offers a 3.8% dividend yield.
Given that interest rates are at ~5% right now, none of these REITs even comes close to offering a comparable cash flow yield, much less a comparable dividend yield. Yes, they do generate cash flow growth, but the margin of safety in these is much lower and - given their immense size - the law of large numbers makes sustaining that growth much more difficult.
Even one of the most attractively priced REITs among its top holdings - Realty Income ( O ) - only offers a 5.1% dividend yield that is roughly in-line with the current risk-free short-term interest rate. Moreover, its growth is slowing to a low single digit annualized pace as it has gotten so large that it is getting difficult for it to sustain a mid to high single digit per share FFO CAGR without undermining its underwriting quality or leveraging up its balance sheet.
On top of that, in the rest of its portfolio it inevitably also holds some pretty bad REITs that have some combination of being grossly overvalued, poorly managed (especially those REITs that are externally managed), having a weak balance sheet, and/or having a low quality real estate portfolio. In this sense, VNQ suffers from "diworsification" by holding more positions than is necessary for sufficient diversification and as a result holding a bunch of REITs that are strong candidates for underperformance.
Furthermore, these premium valuations mean that VNQ's dividend yield tends to be relatively weak relative to what many REITs offer, given that REITs are primarily income investments. As a result, VNQ is not only poised to deliver underwhelming total returns, it is also a less than ideal passive income investment.
The effect of these factors is reflected in VNQ's lackluster long-term total return performance. Over the past decade, VNQ has only generated 66.59% total returns, equating to a weak 5.2% annualized total return. In contrast, utilities ( XLU ) more than doubled VNQ's total return over that period, and the larger indexes ( DIA )( SPY ) trounced VNQ by even more:
Even more concerning for VNQ is the fact that its current dividend yield trails the Federal Funds Rate for the first time in years:
This implies that it is a less-than-ideal income investment. With interest rates at elevated levels and many commercial real estate cap-rates being slow to adjust, it is more important than ever to insist on meaningful discounts to NAV and high cash flow yields when buying REITs today. Otherwise, if elevated interest rates persist, many REIT investors are setting themselves up for very disappointing total returns. For the reasons stated in this article, we believe VNQ's portfolio is filled with REITs that have not sufficiently priced in the higher interest rates and therefore VNQ as a whole is likely doomed to continued underperformance.
Three REITs To Buy Instead
Instead of investing in VNQ, we believe investors would be better served by purchasing the following high-yield blue chip REITs that you will not find in VNQ's top 10 holdings list:
#1. W. P. Carey ( WPC )
WPC primarily invests in industrial and warehouse real estate in the US and Europe, but also has exposure to office, retail, and personal storage real estate. Around one-third of its rent comes from investment-grade tenants, and it owns a diverse portfolio of around 1,500 properties. WPC focuses on investing in strategic locations and mission-critical assets for its tenants, with most of its rent CPI-linked, which is rare in the triple net lease sector. Despite COVID-19 challenges, WPC showed resilience and outperformed most other triple net lease REITs, demonstrating the strength of its underwriting.
WPC also has a very strong balance sheet and recently received a BBB+ credit rating upgrade from S&P. Its near-term debt maturities are almost all higher interest rates, insulating it pretty well from debt refinance headwinds in the current elevated interest rate environment.
Its valuation appears attractive as well with a 14.1x price to AFFO ratio and a 16.6x EV/EBITDA ratio, both lower than its five-year averages. Additionally, its portfolio has shifted towards industrial real estate, and its credit rating has improved. With a 5.7% forward dividend yield and a high percentage of CPI-linked rent increases contributing to strong same-store NOI growth, WPC provides a combination of high yield and growth potential alongside a very low risk profile.
#2. STAG Industrial ( STAG )
STAG's business model consists primarily of making value-add investments in industrial real estate in secondary markets. It acquires properties with high vacancy rates or short lease terms at a discount to the market value and uses its resources to create value, offering greater downside protection during economic downturns.
STAG has a low-leverage balance sheet with an investment grade BBB credit rating from S&P, $847 million in liquidity, and mostly fixed-rate unsecured debt. This makes it well-suited for a stagflationary environment, providing flexibility and minimal increase in relative interest expense.
Furthermore, STAG has significant growth potential, currently owning less than 1% of its total addressable market. To fund its acquisitions, management has focused on maximizing retained cash flows. In 2023, STAG expects acquisition volume between $300 million and $700 million with a cash capitalization rate between 5.75% and 6.5%. Analysts predict a 5-6% CAGR in AFFO per share, supported by acquisitions and favorable re-leasing spreads.
When combining its historically elevated 4.7% current dividend yield, strong growth profile, historically discounted 16.3x price to AFFO ratio, and its 0.88x price to NAV ratio, STAG appears poised to deliver low risk double digit annualized total returns for the foreseeable future.
#3. Spirit Realty Capital ( SRC )
SRC has a low-risk business model that involves leasing out a diversified portfolio of single-tenant real estate on long-term triple net leases to various tenants across different industries. Its 2,115 properties leased to 351 tenants provide diversification, and it has a lengthy weighted average lease term of 10.4 years. SRC's portfolio performed well during the pandemic, and it generates about 20% of its rent from investment grade companies. Meanwhile, SRC is increasing its allocation to industrial assets, with 41% of its acquisition spending in the past twelve months going towards this sector.
SRC has a solid BBB credit rating, with 6.4 years weighted average term to maturity for its debt and a conservative fixed charge coverage ratio of 5.2x. It has no debt maturing in 2023-2024, with only a $301 million term loan maturing in 2025. Additionally, its debt is 99.9% unsecured and 98% of it is at fixed interest rates.
Most importantly of all, SRC's valuation is quite attractive. Its current dividend yield is 7.1%, its price to AFFO is 10.5x, and its price to NAV is 0.89x (whereas most of its peers trade at meaningful premiums to NAV), all of which imply that it is deeply undervalued despite being a pretty low risk investment.
Investor Takeaway
VNQ - with its low expense ratio and decent diversification - may be a decent choice for investors who want completely passive and low-cost exposure to U.S. commercial real estate.
That said, while VNQ lures investors in with its low expense ratio and appearance of broad diversification, its market cap weighted approach makes its diversification a bit overstated. Furthermore, its lackluster dividend yield and poor track record make it a subpar REIT investment for both passive income and total return oriented investors. With the portfolio dominated by overpriced large cap REITs that have failed to properly price in higher interest rates for longer and rounded out by several low quality REITs, VNQ is likely to continue generating underwhelming results for shareholders.
Instead, we believe investors can achieve vastly superior income along with much better total return potential by investing in REITs like WPC, STAG, and SRC. Each of these REITs qualifies as low risk in our view, meaning that investors are not taking on excessive risk in pursuit of these higher yields and total returns. As a result, investors can invest in the REIT sweet spot by investing in REITs on a value basis with attractive current income yields without going out far at all on the risk spectrum.
For further details see:
Forget VNQ, Buy These 3 High Yield Blue-Chip REITs Instead