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Declines in the publicly-traded REIT space have dragged real estate ETFs down along with them, and investors that were hoping to ride a rebound may have to wait a little longer.
Because a significant portion of ETFs are built with REIT stocks, the fate of real estate ETFs is closely correlated to performance in the public REIT sector. Publicly-traded REITs, along with other equities, had a rough 2022 in the wake of aggressive Fed rate hikes. Following a year of where total returns declined 25%, the sector has been roughly flat year-to-date with total returns at 0.33% as of April 5, according to the FTSE Nareit All Equity REIT Index.
This also comes amid a storm of headlines of in the wake of troubles in the regional bank sector predicting doom for commercial real estate with values dropping by as much as 40 percent from peak-to-trough. But some observers say that the decline in real estate values has already been priced into REIT stocks while private real estate options have not yet fully adjusted.
“The good news from this is that public REITs are now repriced for the new, higher, interest rate environment,” says Greg Kuhl, portfolio manager, Global Property Equities at Janus Henderson Investors, which manages the Janus Henderson US Real Estate ETF (JRE). “As we sit today, this should make public REITs a drastically more attractive real estate allocation option than non-traded or private REITs, whose managers have yet to report any write-downs,” he adds.
Certainly, investors have been eyeing the arbitrage in value between listed and non-traded REITs, with many publicly-traded REITs that are trading at a significant discount to net asset value. However, views are still mixed on whether REITs and real estate ETFs represent a buying opportunity or if it’s a chance to catch the proverbial falling knife if there is more fallout to come.
Performance for the real estate ETF sector has been tracking closely with the public REIT index with the asset weighted average return for 2022 at -25.5%, according to CFRA Research. However, performance also is heavily skewed by one passive fund, Vanguard Real Estate ETF (VNQ), which at $31.4 billion in asset value represents nearly half of the $66 billion in total real estate ETF sector volume as of March 27, according to CFRA Research. VNQ posted negative returns in 2022 that totaled -26.7% with year-to-date returns through March 27 of -3.7%.
Poor performance along with market uncertainty has contributed to net outflows of capital. In 2022, real estate ETFs saw $4 billion in outflows relative to $600 billion in inflows, according to CFRA. “In general, the sector has been under some pressure as it is a very rate-sensitive sector because of the debt. So ever since rates have been rising, the sector has been under pressure in terms of performance,” says Aniket Ullal, head of ETF data & analytics at CFRA Research. Real estate ETFs year-to-date through March 27 have seen capital outflows of $1.9 billion. In comparison, the broader U.S. ETF market has seen inflows of $68 billion.
Rocky ride for fund managers
The past 12 to 18 months have been tough for fund managers to navigate. Residential REIT Income Fund (HAUS) is one new fund that launched in March of 2022. HAUS had a strong start, and then it was hit by the war in Russia, rising interest rates, inflation, concerns about a potential recession and now the banking crisis. “From a high level, it feels like one pie in the face after another,” says David Auerbach, managing director of Armada ETF Advisors, which manages HAUS.
Market challenges also have stalled what had been good momentum in the number of sponsors and total asset value for the real estate ETF sector. Currently, there are 62 real estate ETFs in the U.S. with total assets that totaled $66 billion as of March 27 compared to 57 real estate ETFs with $73.3 billion in assets as of March 31, 2021, according to CFRA.
However, industry participants are quick to point out the difference in performance between passive funds, such as VNQ, and actively-managed funds. “Real estate is somewhat unique as an equity sector in that the average active manager has outperformed passive on a long-term basis. This isn’t true for broader equities, which is why we think active real estate ETFs should continue to be a compelling opportunity for investors,” says Kuhl.
Over the last 12 months, net flows have been positive $126 million for active real estate ETFs and net flow negative $6.95 billion for passive real estate ETFs, according to Janus Henderson Investors. The firm tracks a slightly smaller real estate ETF universe as compared to CFRA Research. It’s data covers 26 passive funds and 10 active funds that had roughly $61 billion in asset value as of Feb. 23.
There also are some specialized strategies that are outperforming their peers. Notably, the Pacer Industrial REIT ETF (INDS) is up above 8.5% as of March 30, which is better than the S&P 500 at 5.97%, according to CFRA Research. However, one of the big obstacles for fund managers is market perception, with investor concerns related to the strength of regional banks and tightening liquidity for commercial real estate weighing on REITs.
“We agree that bank debt is likely to be less available for CRE in the near term. However, what many investors fail to appreciate is that commercial real estate is about 90% owned by private vehicles, and only 10% by public REITs,” says Kuhl. Public REITs are less reliant on bank debt and instead rely on the unsecured corporate bond market, which has been proven to be open in recent weeks on attractive terms, he adds. In addition, real estate ETFs are feeling some of the negativity surrounding stress in the office sector even though public REITs have limited exposure, he adds. Office represents less than 6% of the U.S. public REIT market cap, according to Nareit.
According to Auerbach, one of the keys for managers in navigating the current market volatility is to focus on fundamentals and ignore some of the rest of the noise that is weighing on the market. High interest rates are testing REIT management teams. “In times like these, you see who’s good at what they do. I think a lot of these guys are just trying to do business as usual and ignore all of the obstacles that are being thrown at them,” says Auerbach. Overall, Auerbach believes investors still want to have a portion of their portfolios invested in real estate. “Especially if you look in times of rising interest rates and rising inflation, historically the REIT sector has outperformed in the long term,” he adds.
New entrants favor targeted strategies
Although 2022 saw the launch of seven new real estate ETFs in 2022, the pace of new launches has slowed amid market volatility. DoubleLine Capital LP launched two new funds in March, the DoubleLine Commercial Real Estate ETF (DCMB) and the DoubleLine Mortgage ETF (DMBS). Another new entrant is the Non-Traded REIT Fund Tracker ETF. Following the launch of HAUS last year, Armada ETF Advisors and Toroso Investments have filed documents with the SEC to launch the actively-managed fund, which reportedly will invest in publicly-traded REITs and mortgage-backed securities that have some similar characteristics to a basket of nontraded REITs.
It also is worth noting that real estate ETFs is a very top-heavy space, with the top three ETFs accounting for about 60% of total real estate ETF assets. Vanguard is followed by the Schwab US REIT ETF (SCHH) at $5.4 billion and the Real Estate Select Sector SPDR Fund (XLRE) at $4.4 billion. “It is a very concentrated space, and because of that it is challenging for the smaller players to make headway, especially against Vanguard,” says Ullal. “Having said that, I think the areas where funds could grow is by being more specialized.” Those ETFs specializing in industrial, data centers and sustainability are generating more interest from investors, he adds. Two of the new entrants last year were “green” real estate ETFs with a strategy that focuses on REITs that have strong sustainability strategies.
The rocky climate also is expected to result in some fallout among the weaker funds. It is still early days for real estate ETFs, and many of the funds that have launched in the past two years are still relatively small in total asset size. “I do think you’re going to see some shakeout. You’ve already seen some shakeout in some of the other ETFs that came out during COVID that didn’t gain any momentum and shuttered,” says Auerbach.
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