2023-12-05 09:49:59 ET
Summary
- Vanguard Real Estate ETF offers instant diversification to the real estate index with a low expense ratio of 0.12%.
- The fund has a modest dividend yield of 4.3% and potential for growth due to the Federal Reserve's anticipated lowering of interest rates.
- However, there is a risk of underperformance compared to holding individual REITs, and prolonged suppression of VNQ's price if interest rate cuts are delayed.
Overview
Vanguard Real Estate ETF (VNQ) is a fund that primarily invests in the public equity markets of the United States, focusing on companies within the REITs (real estate investment trusts) sector. It pursues a strategy of investing in both growth and value stocks across diverse market capitalizations. Launched on May 13, 1996, Vanguard Real Estate ETF aims to achieve a high level of income and moderate long-term capital appreciation.
VNQ has a modest dividend yield of 4.3%. Although this may not be considered high yielding in this current environment of high yield savings accounts and treasury bonds offering 4%, I still believe the fund offers incredible value to those looking to get exposure to the real estate index. This is especially true for investors who may not feel confident enough to soft through the thousands of REITs in existence and would rather own an index that offers instant diversification while providing a stress free holding. There is one catalyst that makes me believe VNQ will be a great buy going into the new year. The Fed lowering interest rates. I will discuss more below so let's dig in!
Portfolio
The reason I think this fund is specifically great for beginners is because it's low cost with an expense ratio of only 0.12% and it offers instant diversification to several sectors. The 0.12% expense ratio is significantly below the 0.48% median observed across the broader ETF universe. VNQ holds 160 individual stocks with a median market cap of $22.6 billion. The portfolio is comprised of high quality companies that have a combined average earnings growth rate of 11.4% annually over the last 5 years.
The largest portion of the portfolio is made up of Telecom Tower REITs, such as American Tower ( AMT ), which I previously rated as a Buy in my recent analysis . This is closely followed by Industrial REITs coming in at 12.10%, such as STAG Industrials, which I also rated as a Buy and has now returned 15% since published . I have put together a table and sorted it the portfolio's composition from largest to smallest.
Sectors | VNQ | Benchmark |
---|---|---|
Telecom Tower REITs | 12.90% | 12.80% |
Industrial REITs | 12.10% | 12.00% |
Retail REITs | 12.70% | 12.70% |
Multi-Family Residential REITs | 8.60% | 8.90% |
Health Care REITs | 8.40% | 8.50% |
Self-Storage REITs | 6.20% | 6.10% |
Other Specialized REITs | 6.10% | 6.40% |
Real Estate Services | 6.40% | 6.30% |
Single-Family Residential REITs | 4.90% | 4.80% |
Office REITs | 4.30% | 4.20% |
Timber REITs | 2.50% | 2.50% |
Diversified REITs | 2.10% | 2.10% |
Hotel & Resort REITs | 2.80% | 2.80% |
Diversified Real Estate Activities | 0.20% | 0.20% |
Real Estate Development | 0.20% | 0.20% |
Real Estate Operating Companies | 0.40% | 0.40% |
Great Buying Opportunity
Throughout the past year, REIT prices were absolutely hammered. VNQ only recently saw some price recovery and is now up 2.1% YTD. VNQ held up much better in comparison because of the diversified exposure to all forms of real estate. However, prior to the recent spike in price, REITs were down overall because of multiple factors. One significant contributor to this downturn was the impact of rising interest rates.
As interest rates climbed, the cost of borrowing increased for REITs, affecting their profitability and financial performance. REITs often rely on debt to fund property acquisitions and expansions. When faced with higher financing expenses, REITs were under scrutiny and prices fell.
Simultaneously, the landscape of work dynamics and the accelerated adoption of remote work played a role in diminishing demand for office buildings. It seemed that any REITs with exposure to office buildings were hit the hardest. This is apparent when you look at office based REITs such as SL Green Realty ( SLG ), which fell from a high of $94/share at the start of the pandemic and now sits at $42/share. The REITs focuses on a portfolio of office buildings within Manhattan. The COVID-19 pandemic prompted a widespread reassessment of the traditional office space model, with many companies embracing hybrid work arrangements or fully remote setups.
Right now remains a great buying opportunity for VNQ. The price is still 25% off price the highs of 2021 and the portfolio holds lots of quality names with strong balance sheets and great credit ratings.
Catalyst: Lower Interest Rates
The biggest catalyst for price increase will be the Fed lowering interest rates throughout 2024. It is believed that the Fed will cut interest rates 6 times throughout next year.
Lower interest rates are advantageous REITs for several reasons. Firstly, decreased borrowing costs benefit REITs that often rely on debt for property acquisitions and expansions. Lower interest rates make borrowing more affordable, enhancing the profitability. Additionally, the income generated by REIT dividends becomes more attractive to investors in a low-interest-rate environment, as alternative fixed-income investments may offer lower yields. This heightened income yield can drive demand for REITs, positively impacting their stock prices, which will result in VNQ capturing some nice upside.
Lastly, lower interest rates tend to support higher asset valuations for real estate, as the present value of future cash flows increases when discount rates decline. Central banks often implement lower interest rates as a stimulus during economic challenges, which can further benefit REITs by fostering economic growth and increasing demand for various types of real estate.
Dividend
VNQ has had paid dividends out for 17 consecutive years. As of the latest declared dividend of $0.7268/share, the current dividend yield comes out to 4.3%. The average year-end dividend between 2019 - 2022 has been around 3.45%. The current yield of 4.3% could indicate that the ETF is historically undervalued from this aspect and you would be starting a position at an attractive entry point.
There is one caveat here though: the dividend growth has been poor. The dividend CAGR over the last 5 year period is actually negative at -1.38% compared to the sector median growth of 5.68%. If you are looking for a consistently growing dividend, you would be better off buying one of the funds top holdings.
For example, here are some of the stocks within VNQ with exceptional dividend growth history.
- Realty Income ( O ): 29 consecutive years of dividend growth. Previously rated as a Strong Buy
- American Tower ( AMT ): 5 year dividend CAGR of 16%. Rated a Buy.
- VICI Properties ( VICI ): Recently raised their dividend 6.4%
- Federal Realty Investment Trust ( FRT ): Reached Dividend King status with over 56 years of dividend growth.
Risks
The main risk here is underperformance compared to if you were to hold a single REIT. For example, here is a total return comparison over the last 5 years of VNQ versus some of its top holdings:
So while VNQ can definitely mitigate some risk by offering a wide array of exposure across the industry, you can also limit your total returns going forward. You would also likely miss out on some dividend growth compared to what some other REITs would be able to provide over the same period.
In addition, if rate cuts were to be delayed and we stayed in an environment with high rates, VNQ's price could stay suppressed for longer. Elevated funding costs can constrain the ability of REITs to pursue new acquisitions or expand existing property portfolios. This has the potential to impede their growth trajectory.
A result of this would be that the increased interest expenses associated with higher interest rates are likely to affect the profitability of the REITs within VNQ. As interest payments rise, it can reduce the net income available for distribution to shareholders in the form of dividends, thereby affecting the overall attractiveness of VNQ as an income-generating investment. This holds especially true when you consider that there are plenty of REITs out there yielding larger amounts than VNQ.
Takeaway
Vanguard Real Estate ETF has a modest dividend yield of 4.3%. Although VNQ may seem less attractive in the current environment of high-yield savings accounts and treasury bonds, its unique value proposition lies in providing instant diversification for those seeking exposure to the real estate index. The fund's low expense ratio of 0.12% further enhances its appeal.
A significant catalyst for VNQ's potential upside lies in the Federal Reserve's anticipated lowering of interest rates throughout 2024. Lower interest rates can benefit REITs in multiple ways, including decreased borrowing costs, enhanced profitability, and increased attractiveness to income-seeking investors. This, combined with the support for higher asset valuations, positions VNQ for potential growth in the coming year.
Despite its merits, VNQ carries certain risks, notably the potential for underperformance compared to holding individual REITs. The fund's total return history, while offering diversification benefits, may limit potential returns compared to investing directly in specific real estate sectors. Additionally, if interest rate cuts are delayed or we remain in a high-interest-rate environment, VNQ's price could face prolonged suppression, impacting its attractiveness as an income-generating investment.
For further details see:
VNQ: Great Buy Going Into 2024