Income investors should not go overboard with overweighting their real estate investment trust exchange traded fund exposure as valuations have grown expensive.
“That big, unexpected fall in interest rates – is there any other kind than an unexpected fall or an unexpected rise? – has really inflated (and I think that’s the right word, ‘inflated’) the value of most real estate investment trusts that are out there,” Josh Peters, director of equity-income strategy at Morningstar, said.
Peters points out that there are no longer many REITs trading below fair value as most options are trading at big premiums to fair value estimates. The strategist also warned that the rush into REITs has significantly depressed yields in the space to the point where returns may no longer justify potential risks. Consequently, he argues that there is no margin of safety to commit new money to the space.
“To look at the whole group of REITs that are members of the S&P 500 Index and having that dividend yield down around 3%, that’s the kind of number that I’d choke on,” Peters added. “I have been in this game a long time; I can remember when you had high-quality, ‘money good’-type REITs paying 6%, 7%, or 8%.”
For instance, popular REIT ETFs are trading at higher valuations and lower yields after falling rates pushed investors to alternative income-generating assets. The Vanguard REIT ETF (NYSEArca: VNQ) has a 3.37% 12-month yield and trades at a 39.4 price-to-earnings ratio, iShares Dow Jones US Real Estate Index Fund (NYSEArca: IYR) has a 3.47% 12-month yield and a 34.8 P/E ratio, and SPDR Dow Jones REIT ETF (NYSEArca: RWR) has a 2.87% 12-month yield and a 46.1 P/E.
The slightly more rate-sensitive mortgage REITs, though, still show relatively low valuations and provide high yields. The Market Vectors Mortgage REIT Income ETF (NYSEArca: MORT) has a 10.1% 12-month yield and a 9.2 P/E while the iShares Mortgage Real Estate Capped ETF (NYSEArca: REM) has a 14.59% 12-month yield and a 9.1 P/E. [Financial Sector ETFs to Generate Yields]
Despite potential rate risks, Peters remains positive on the space as economic fundamentals could continue to support growth.
Fund managers argue that while the real-estate funds may experience short-term swings due to interest rate changes, the funds’ underlying outlook remains positive, pointing to a growing U.S. economy, improving employment rate and greater foreign investment demand for U.S. REITs. [Fundamentals to Support REIT ETFs, Outweighing Rate Risk]
For more information on real estate investment trusts, visit our REITs category.
Max Chen contributed to this article.