2023-08-07 06:49:47 ET
Summary
- Schwab U.S. REIT ETF is a popular REIT ETF with a focus on low-cost investing in U.S. equity REITs.
- It has a strong bias towards defensive sectors such as telco tower, industrial, multi-family residential, and data center REITs.
- SCHH has underperformed the S&P 500 and its comparable ETF, VNQ, due to the elevated exposure to interest rate risk and sector-skew facing challenges.
- At the same time, SCHH currently yields below the U.S. 10 Year Treasury and trades at multiples that are in line with well-established and richly priced REITs.
- Given that there are many smaller cap REITs placed in same sectors and with strong balance sheets, but that are trading at way more attractive multiples and higher yields, investing in SCHH does seem attractive.
Here in this article I will focus on the Schwab U.S. REIT ETF (SCHH), which is one of the most popular REIT ETFs carrying over $38 billion in market cap. While the assessment will be obviously skewed towards understanding SCHH, the key takeaways can be also applied for other widely recognized passive REIT ETFs such as Vanguard Real Estate ETF (NYSEARCA: VNQ ) and iShares Cohen & Steers REIT ETF (BATS: ICF ).
So, SCHH invests or tracks the performance U.S. equity REITs in a very low cost manner (0.07% expense ratio). There are no limits on market cap, sector or fundamental metrics as long as the investments do not include mortgage or hybrid REITs.
Looking at SCHH's sector breakdown, we can see that there is a strong bias towards relatively defensive exposures such as telco tower, industrial, multi-family residential and data center REITs. Sectors, which are currently facing major challenges - office, timber and still to some extent hotels - account only for ~ 10% of the total AuM.
The concentration within the Top 10 names is, however, a bit excessive constituting ~ 46% of the total portfolio. However, all of these names carry investment grade balance sheets are of a relatively large size, which comes in handy when lending conditions are tight.
Moreover, Top 3 companies - Prologis (NYSE: PLD ), American Tower Corporation (NYSE: AMT ), and Equinix (NASDAQ: EQIX ) - explain the lion's share of the Top 10 exposure. These REITs are commonly deemed ultra financially resilient with stable and predictable dividends.
Now, if we compare SCHH's TTM 3-year performance to that of VNQ or S&P 500, there is a notable gap. In other words, SCHH has not only underperformed the S&P 500, but also its comparable ETF - VNQ. By looking at the chart above, we can also notice an interesting dynamic, where the performance of all three indices has been relatively equal, but from Q1, 2022 huge divergences were starting to take place. In other words, SCHH has not experienced a notable recovery since the crash in early 2022 when the COVID-19 broke out.
The key reason for that is an overwhelming exposure to telco tower and industrial REITs (i.e., the Top 2 sector exposures of SCHH), which are inherently more exposed to the interest rate risk and currently face headwinds on the long-term demand side. Namely, it is the difference is equity REIT sector exposures that is the key driver of the return discrepancy we see in the chart above.
Thesis against SCHH and passive REIT ETFs in general
In my humble opinion, the prevailing U.S. equity REIT landscape is rather fragmented, where we are seeing pockets of clear distress and at the same time avenues of resiliency and favourable growth.
The difference in the registered performance of SCHH and VNQ capture the essence perfectly showing how critical in this environment it is to allocate into sound sectors.
Plus, I would go even one step further that considering recessionary risks, interest rate uncertainty and REIT sector-specific dynamics it is the right time to assume 'stock-picking' approach.
Let me know give you a couple of facts, which substantiate my thesis of avoiding passive REIT ETF such as SCHH and instead capitalizing on the prevailing market situation by focusing on specific names.
Most of the REIT ETFs including SCHH are biased towards large-cap REITs, which per definition trade at higher multiples. Yet, since the Fed started increasing interest rates many REITs suffered primarily via multiple contraction due to concerns around further refinancings and ability to maintain spreads between cap rates and WACC.
However, it is the small-cap REIT segment, which has been punished the most and as a result trades at relatively more attractive multiples.
Let's take industrial REIT sector, which is SCHH's second largest sector exposure, as an example.
The three largest names in the U.S. equity REIT sector have returned ~ 20 - 25% in the past 3 years.
And here, one of the three smallest REITs in the same sector, have clearly delivered flattish performance. Granted, there are a couple of outliers in both fronts, but the key takeaway (i.e., structural divergence between small and large-cap REITs) remains correct.
Moreover, if we look at SCHH's valuation metrics, we can see that the ETF trades at relatively high multiple. Currently, it is priced at P/CF of 14.2x.
Just for the context, such multiples are common for well-established and extremely large cap REITs, which typically offer stability but not too attractive growth. For example, Realty Income (NYSE: O ), Federal Realty Investment Trust (NYSE: FRT ), Essex Property Trust (NYSE: ESS ), which are all REIT dividend aristocrats trade at P/CF multiple of 14 - 16x.
So, effectively, by allocating into SCHH one assumes exposure towards REITs, which on average are already trading close to relatively un-opportunistic multiples.
Finally, the yield aspect does not seem too attractive either. Currently, SCHH yields 3.2%, which is in line with the yield of FTSE Nareit All Equity REITs, which, in turn, is finding itself in historically unattractive territory.
Compared to the U.S. 10 Year Treasury there is a negative spread due to relatively low yielding portfolio of SCHH.
At the same time, there is a plethora of REITs, which have investment grade balance sheets, but are offering more attractive dividend yields (e.g., O, FRT, ESS etc.).
This aspect is crucial since REIT investing is typically associated with high dividends that are coupled with a growth component, which against the backdrop of mid-teen multiples do not provide attractive entry point for investors.
Bottom line
In my humble opinion, this is not the right time to go long REIT ETF due to the inherent skew towards large-cap, high-multiple and low yielding names. These characteristics help in the environments, where asset prices are depressed and are down in a homogenous manner. Yet, now, when the large cap REITs have come back with a vengeance from the pandemic period, while the smaller cap REITs have traded sideways or recovered in a more balances magnitude, it makes sense to focus on individual names to capture higher yields and better return prospects via further multiple expansion.
Just to give some examples of REITs, which I prefer and which recently have proven that 'cherry picking' small cap names can be attractive:
The Macerich Company (NYSE: MAC ) - Macerich: Secure 7% Yield With A Room For Price Appreciation
Global Medical REIT (NYSE: GMRE ) - Global Medical REIT: 10% Yield With Resilient Fundamentals
Cousins Properties (NYSE: CUZ ) - Cousins Properties Looks Safer Than Others In This Distressed Sector
For further details see:
SCHH: Suboptimal Way To Enter REIT Space