Why I Won’t Buy REIT ETFs

Over the long term, REITs have been among the most rewarding investments, beating not only tech stocks (QQQ) and the S&P 500 (SPY), but also value stocks (IWN), gold (GLD), bonds and most other asset classes. :

Interestingly, REITs have earned these higher returns despite being safer and paying higher returns than most other investments.

Today, REITs are particularly attractive because they are valued at the lowest levels in years and offer inflation protection and valuable diversification benefits in an uncertain world. Historically, REITs have generated even higher returns when inflation is high and interest rates rise, as the positive impact of inflation far outweighs the negative impact of rising rates:

Therefore, most investors will probably agree that they need to have a REIT allocation in their portfolio. But the harder question is how should they get that exposure?

Here you are faced with 2 main options:

• Buy a REIT ETF
• Buy individual REITs

There are pros and cons to both approaches.

If you are a passive investor, know little about REITs and have no interest in knowing about them, the best option is probably to invest in an ETF and hold it for the long term.

This will allow you to gain broad exposure to the sector with relatively low management fees. Vanguard Real Estate (VNQ) is probably the best choice.

I think ETFs make a lot of sense to a lot of people and I myself would use them for certain market sectors. However, when it comes to REITs, I prefer to build my own portfolio by investing in individual REITs.

Here are 5 reasons why:

Reason 1: Pricing errors are common

Today’s stock market is so efficient that it’s nearly impossible for active investors to outperform benchmarks according to many studies.

This is especially true for popular sectors like large cap tech stocks which are reviewed and covered by thousands of analysts worldwide.

But REITs are an exception.

This is still a niche industry and inefficiencies/mispricing are much more common. Real estate investors generally don’t trust REITs or the stock market, and equity investors generally have little knowledge of real estate.

Being a hybrid of the two has placed REITs in an odd category of stocks that often lack a well-informed audience and, unsurprisingly, market inefficiencies and mispricings are more prevalent.

This is also proven by studies which have shown that active REIT investors outperform benchmarks quite easily, and that has also been our experience at High Yield Landlord. We managed to achieve significantly higher returns than REIT ETFs by being more selective.

Reason 2: ETFs invest in mismanaged REITs

ETFs aim to give you broad exposure to a sector. This is great if you’re looking for instant, wide diversification, but it comes at a cost.

Some companies are exceptionally well managed. Others are just average. And then some leadership teams are clearly in conflict and should be avoided at all costs.

Here, it is important to know that REITs can be managed internally or externally.

The preferred management structure is internal because it results in reduced management costs and better alignment of interests with shareholders.

However, to date, there are still many externally managed REITs and they have historically achieved much lower returns due to higher management costs and conflicts of interest.

ETFs also invest in externally managed REITs, which hurts the performance of your investment.

Reason 3: ETFs are mainly invested in large caps

Most REITs are quite small in size. Of about 150 REITs, only about a third are large-cap.

But since most ETFs are market-cap weighted, they will invest most of their capital in large-cap REITs. If you look at VNQ’s top holdings as an example, you’ll notice they’re all massive REITs like Digital Realty (DLR), Public Storage (PSA), and Prologis (PLD).

This is a problem because large caps generally trade at much higher valuations, as you can see from the chart below:

We often find the best opportunities in smaller, lesser-known REITs that are overlooked by most investors.

A good example would be BSR REIT (OTCPK: BSRTF), a Texas-focused apartment REIT that grew its FFO per share by 75% in 2021, yet is currently priced at a discount of 35% to NAV. It is growing faster than its larger peers like Mid-America (MAA) and yet it is much cheaper.

By investing in smaller REITs, we are able to earn higher cash flow for every dollar invested, earn higher dividends, and often enjoy faster growth and a higher edge.

Smaller REITs are of course riskier because their investments are more concentrated, but you can take care of the diversification yourself by holding a portfolio of around 20-25 individual REITs.

Reason 4: ETFs invest heavily in questionable sectors

Today, there are REITs for literally everything. Just to give you an idea, there are REITs that invest in billboards, farmland, and casinos.

Yet ETFs continue to invest heavily in REITs specializing in office buildings, retail and hotels, as historically these have been among the largest REIT sectors.

Offices are suffering from the growth of remote working, made possible by increasingly powerful technologies like Zoom (ZM) and DocuSign (DOCU).

Retail is suffering from the growth of Amazon (AMZN).

And hotels are suffering from growing competition from Airbnb (ABNB).

That doesn’t mean you can’t invest in these sectors, but you can limit your exposure and be more selective.

At High Yield Landlord, we do not invest in office or hotel REITs at this time, and while we find great value in some retail REITs, we are very selective.

Reason 5: ETFs offer too little income and fees

Today, most REIT ETFs pay more or less a 3% dividend yield.

This is not enough for a real estate investment in my opinion.

I believe real estate should increase your portfolio yield and provide high income in times of market volatility.

The return of ETFs is so low because they mainly invest in large cap REITs and they also charge fees. The fees are low, but they add up over time.

I aim to get closer to a 6% dividend yield by being selective. This allows me to remain patient while waiting for a long-term appreciation.

The Proprietary Approach to REIT Investing

At High Yield Landlord, we aim to outperform the broader REIT market by being highly selective. We call it the “ownership” approach because we buy REITs like we buy rental properties.

We are very selective because the money is made at the time of purchase. On average, we only invest in one in ten REITs because:

• We ignore all externally managed REITs that are in conflict
• We stay away from office and hotel REITs for the most part
• Our goal is to buy good REITs at significant discounts to net asset value
• We mainly focus on sectors with strong fundamentals such as agricultural land
• We aim for a return of 5-8% so that we are not solely dependent on appreciation

As a result, we typically end up investing in smaller, lesser-known REITs that go unnoticed:

A good example would be Whitestone REIT (WSR), a small-cap retail REIT that owns service-oriented malls in the rapidly growing Sunbelt markets.

It is offered at a 10% FFO yield and an estimated 35% discount to NAV.

It’s so cheap because the market sees it as just a retail REIT, but what it seems to ignore is that its assets are located primarily in Phoenix, Arizona, and Austin, Texas, which are two of the strongest markets in the whole country. Plus, these service and grocery-focused properties are holding up pretty well against Amazon (AMZN) and even recessions.

The company has guided growth of around 15% in FFO per share in 2022 and its occupancies have much greater upside potential in the years ahead.

We believe that a company of this quality should be trading closer to its net asset value, which means it has an immediate upside potential of around 40%. While we wait, the company generates a 10% cash flow return, of which it pays us 5% in dividends and reinvests the other half in future growth, which will result in greater appreciation.

Conclusion

Individual ETFs and REITs have advantages and disadvantages.

But if you want to learn more about REITs and spend time researching them, you can get significantly higher returns by investing in individual REITs that are undervalued.