Real Estate Passive Income: Don't Buy VNQ

Summary

• REITs look very attractive right now.
• However, we think that VNQ is a bad way to invest in the sector.
• We share three reasons why.

Real Estate Investment Trusts (i.e., REITs) look like a highly compelling sector to invest in right now for several reasons:

1. On average, they currently trade at a deep discount to the private market value of their underlying real estate holdings. At a time when the rest of the market is overvalued, value can be hard to find. It is certainly available in the REIT sector.
2. Leading real estate investors like Blackstone (BX) are pouring billions of dollars into buying REITs hand-over-fist.
3. There are trillions of dollars sitting in cash right now that is ready to pour back into REITs once the Federal Reserve finally decides to cut short-term interest rates.

As a result, some investors who are not otherwise familiar with the REIT sector may be tempted to simply buy the Vanguard Real Estate Index Fund ETF (NYSEARCA:VNQ). After all, it charges a very low 0.12% expense ratio, offers a decent 4.1% trailing twelve-month dividend yield, and is very well diversified with 163 holdings. Moreover, with over $62 billion in assets under management, it offers investors tight bid-ask spreads and even the ability to trade options with decent liquidity if they so desire.

In our view, however, there are several reasons why VNQ is not a worthwhile REIT investment right now:

#1. Poor Long-Term Performance

The first big reason is that VNQ has delivered quite poor long-term total return performance. For example, over the past decade, VNQ has not only underperformed the tech-heavy Nasdaq (QQQ) and S&P 500 (SPY) by a wide margin (which is not surprising given that the market has been in a long-running tech boom), but it has also underperformed fellow high-yield sectors such as BDCs (BIZD) and utilities (XLU):

As a result, even against other sectors - like utilities - that suffer and benefit similarly from rising and falling interest rates and tend to generate stable long-term cash flows, VNQ has proven to be a subpar investment.

#2. Unattractive Dividend Investment

Moreover, VNQ is not particularly compelling to dividend/passive income investors either. First of all, its 4.1% dividend yield is well below what is being offered by CDs and short-term treasuries (SGOV) right now. Moreover, even relative to other REIT funds, its yield seems to be on the low side, as the Cohen&Steers Quality Income Realty Fund (RQI) offers an 8.1% TTM yield and the Hoya Capital High Dividend Yield ETF (RIET) offers a 10.2% TTM yield.

Moreover, VNQ's three-year dividend CAGR is just 1.56% and its 10-year dividend CAGR is 2.27%. Those growth rates do not even keep up with inflation, making it a very poor dividend growth investment.

With a mediocre dividend yield and very poor dividend growth from a fund that holds what are supposed to be yield-focused investments, why bother?

#3. Active Investing Is Superior With REITs

Last, but not least, skilled active investing has proven to generate superior returns to passive investing in the REIT sector. This is due to three main factors:

1. REITs more than many other sectors often attract external management teams. These REITs - such as Global Net Lease (GNL) was until very recently - are notorious for misallocating shareholder capital and adopting a growth-at-all-costs mindset that destroys shareholder value over the long term. Passive index funds do not discriminate between these REITs and ones with prudent management teams, whereas active management teams can weed out the perennial losers and misallocators of capital like GNL.
2. Passive REIT funds like VNQ are also market cap-weighted, often pushing up the valuation of large-cap REITs through blind purchasing of their shares without actually examining their fundamentals, outlook, and valuation to see if they actually deserve additional capital. This creates inefficiencies in the REIT sector that active investors can potentially exploit.
3. REITs are often valued by generalist investors and analysts as stocks, when in reality they are diversified, professionally-managed portfolios of physical real estate. As a result, there is often a wide spread in the public and private market valuations. Experienced REIT investors who view them as real estate portfolios rather than simply stocks often can gain an edge by adopting a long-term and private market value-oriented mindset instead of viewing them as stocks like other companies in the market with a hyper-focus on P/FFO multiples and FFO growth rates (though these factors are also important).

As a result, we should not be surprised to see that funds like RQI and the ALPS Active REIT ETF (REIT) have significantly outperformed VNQ:

Investor Takeaway

While VNQ looks like a simple way to invest in REITs (and it is), it is not a winning way to do so. As history has shown, VNQ has not only underperformed other sectors - including fellow interest rate-sensitive high yielders like utilities - but has also materially underperformed actively managed REIT funds.

As a result, while we are certainly bullish on REITs right now for the reasons mentioned at the beginning of this article, our approach is to buy individual REITs employing a value-oriented and long-term approach as if we were investing in physical real estate. This approach has served us very well and generated significant outperformance over time.

However, for investors who still want to invest in a diversified REIT fund, actively-managed 8.1%-yielding RQI looks like a compelling opportunity as well.