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One of the most popular methods of investing in real estate is through real estate investment trusts, or REITs. In order to receive a favorable tax classification, REITs are required to dispurse at least 90% of their distributable cash flow to investors as dividends.
This results in high yields across REITs, which are attractive to income investors in this low rate environment. Investors who are interested in investing in real estate can gain exposure through REITs. For those who are uncomfortable with purchasing individual securities, many financial institutions have created exchange-traded funds, or ETFs, designed to invest in a basket of REITs. This provides investors with the benefits of diversification, as well as minimal annual fees that are significantly lower than most mutual funds. Here are three of the best real estate-related ETFs that investors should consider for sources of income.
One of the best REIT ETFs investors can buy is the Vanguard REIT ETF (VNQ). Vanguard is widely known for having some of the lowest-fee ETFs in the financial industry. Indeed, the annual expense ratio for VNQ is just 0.12%, which according to Vanguard is 91% lower than the average expense ratio for similar REIT funds. VNQ is a diversified real estate fund with 150 different holdings. Its top 10 holdings comprise 35% of its total assets. It is also diversified among equity sector. Its highest concentration is 24% in retail REITs. Its next highest allocations are 16% specialized REITs, 15% residential REITs, and 12% health care REITs.
Over the past one year, VNQ has distributed $2.74 per share in dividends. Its trailing 12 month dividend represents a 3.3% yield based on its current share price. VNQ has a very successful long-term track record of returns. The fund generated a 9.6% annualized return since its inception in 2004.
IYR (IYR) also has a low expense ratio of 0.43% but this is significantly higher than VNQ. Another difference is that IYR is more concentrated. It has 117 holdings in its portfolio. It has a much higher weighting toward specialized REITs (27% of assets) and retail REITs (19% of assets). By comparison, it has almost very low exposure to industrial REITs, hotels, and mortgage REITs.
However, the trade-off is that IYR has a higher dividend yield. Its trailing 12-month yield is 4.1%. This is extremely attractive as the S&P 500 average dividend yield is only about 2%. It has some higher-yield REITs in its portfolio that generate a higher total yield for the fund. Another margin of safety for IYR is that it has less volatility than the broader equity market. Its beta value is 0.95, which means that for every 1% move in the S&P 500, it will move 0.95%.
RWR (RWR) has a modest expense ratio of 0.25% and a satisfactory dividend yield of 3.71%. It has 96 holdings in its portfolio. The fund is more heavily geared toward residential REIT; 17% of holdings are concentrated in apartment buildings. Its next highest allocations are 15% to regional malls and 11% to health care REITs. No single REIT represents more than 10% of its assets.
RWR has an excellent historical performance record. It has achieved 11% annualized returns since inception in 2001.
There are also risks to investing in REITs that investors should know. First and foremost is interest rate risk. REITs and other real estate investments are highly sensitive to changes in interest rates. REITs utilize debt to purchase properties, which are then rented out to collect income. When interest rates rise, it increases their cost of capital. This typically causes interest expense to rise, thereby negatively impacting profitability. The Federal Reserve has signaled its intention to raise interest rates. If the central bank delays further, it would likely be a positive catalyst for REITs.
Even if the Federal Reserve does raise the Fed Funds rate, which is the bank-to-bank lending benchmark rate, it will likely be a small increase. From there, it is also likely the Federal Reserve will continue to take a cautious approach and raise rates slowly over time, so as not to endanger the fragile economic recovery in the United States. As a result, it is likely that the above-average dividend yields offered by REITs will still be attractive to income investors, even if interest rates rise slightly this year.
Real estate investment trusts make money by purchasing properties and then leasing them to tenants. REITs can specialize in a wide variety of industry focuses, including retail, health care, or technology. Interest rates remain near historic lows, as the U.S. Federal Reserve continues to delay raising interest rates. This has resulted in very low yields across most asset classes. However, interest rates are likely to rise at some point. Still, interest rate increases will be modest for several years, which means REITs should still generate enough cash flow to sustain their high dividends.
The high yields for these REIT ETFs are very strong yields in today’s investing climate. As a result, income investors who are searching for above-average yields should consider diversifying their portfolios to include some REIT ETFs.