New REITs Sector Trips, Drags on Popular Dividend ETF Plays

Real estate investment trusts are trying to make it on their own with a new sector classification, but the asset category has underperformed in its first foray into the market. While a lot of attention has been focused on market capitalization-weighted indexing changes, investors should also closely monitor popular dividend exchange traded funds with heavy exposure to the weakening sector.

REITs recently broke away from the S&P 500 Financial Sector and are now considered a standalone sector apart from banks, insurers and other financial services companies, accounting for 3% of the S&P 500 market capitalization. However, REITs have recently been underperforming the financial sector.

Since September 16 when REITs made a break from the financials sector, the Real Estate Select Sector SPDR Fund (NYSEArca: XLRE), a REITs-specific ETF based on the new S&P 500 sector, declined 3.1%, whereas the Financial Select Sector SPDR (NYSEArca: XLF) gained 1.8%.

REITs, which are traditionally popular for their attractive dividend yields, have come under fire in recent week as improved U.S. economic data fueled speculation of a pending Federal Reserve interest rate hike. Some investors fear REITs will act negatively in rising interest rate environment – higher interest rates means that REITs’ interest payments go up, so the companies have less cash flow available for dividends. The high dividends in REITs are attractive in a low-rate environment but are less enticing once safer Treasuries show higher rates.

REITs are securities that trade like a stock and invest in real estate directly through property ownership or mortgages. Consequently, revenue is mainly generated through rent or interest on mortgage loans. To qualify for special tax considerations, the asset also distributes the majority of income, about 90% of taxable profits, to investors as dividends.

With increased interest rate risks ahead, investors who hold dividend ETFs for yield generation should monitor their exposure to the REITs sector.

“While attention had been focused on the impact to the market-cap weighted diversified and sector-specific S&P and MSCI indices, much insight can now be gleaned about increasingly popular alternatively weighted ETFs and active mutual funds. For example, there is a wide range of real estate exposure for popular dividend ETFs and mutual funds.” Todd Rosenbluth, Director of ETF & Mutual Fund research, said in a note.