Fixed-income investors should consider real estate assets and sector-related exchange traded funds as an alternative asset to diversify a fixed-income portfolio.
“Real estate is an important component of any diversified portfolio due to its low correlation with other asset classes and potential to provide inflation protection, dividend income, high returns and growth, and tax advantages,” Kevin Davis, Chief Growth Officer for Vident Financial, said on the recent webcast, The Secret to Investing in Real Estate ETFs.
Real estate has exhibited a strong track record as an inflation hedge and long-term store of value. Specifically, the assets can capitalize on higher rental income as inflation rises. Standard lease terms also protect landlords from cost inflation since tenants are usually responsible for operating costs such as utilities, insurance, and maintenance. In the period 1978 through 2011, real estate investment trusts provided inflation protection success rates of 65.8%, compared to gold’s 43.2% success rate.
More importantly, for fixed-income investors, real estate offer high, stable dividends that can complement or provide an alternative to bonds as a source of income. Real estate provides yields that currently exceed sovereign and corporate investment grade debt. Unlike bond coupons, real estate dividends are able to grow over time, which is especially valuable in high growth and inflation environments. Furthermore, long-term leases have provided more reliable dividends compared to other equities.
During high growth environments, real estate has shown the potential to generate competitive returns comparable to other equities and fixed income assets. Meanwhile, unlike most equities, real estate is better positioned for low growth conditions due to stable dividends.
Real Estate Among Best Performers
“Historically, real estate is among the best performing asset classes. Allowing investors to seek to benefit from real estate’s inflation protection and stable income,” Davis said.
To capitalize on the benefits of real estate investment trusts and gain smarter exposure to the real estate sector, ETF investors may consider something like the U.S. Diversified Real Estate ETF (NYSE Arca: PPTY).
Fred Stoops, Head of Real Estate Investments for Vident Financial, explained how PPTY’s portfolio is constructed based on the actual properties held by each company in the investment universe. The smart beta index-based ETF screens for four primary factors when investing in real estate, including location, property type, leverage and governance.
Location can affect the value of a property and is a key driver of real estate performance. Stable targets are used to diversify geographic exposure while favoring dynamic, high-growth locations.
Differences between property types also produce varying results. The fund’s fixed allocations seek to ensure diversification and balance.
Responsible use of leverage can also enhance returns, but excessive debt often creates unnecessary risk for investors, especially during economic downturns. PPTY’s portfolio seeks to reduce allocations to companies with high debt in favor of firms with strong balance sheets for a more quality tilt.
Lastly, companies with significant governance risks are excluded from the portfolio to diminish unforeseen risks. The underlying index utilizes two criteria to mitigate governance risk, including external management and low free float percentage.
Due to its indexing methodology, PPTY has a greater tilt toward potential growth segments like residential and industrial real estate, whereas traditional market-cap indices favors the retail segment, which has come under greater stress due to changing consumer habits.
For example, Jerry Bowyer, Chief Economist for Vident Financial, pointed to the shift toward e-commerce and away from traditional brick-and-mortar stores. E-commerce represents 9% of retail sales in the US, 14% in the UK, and 23% in China. Looking ahead, the e-commerce market is projected to expand at a 12% annual rate through 2025.
Consequently, PPTY’s underlying index incorporates specific considerations in real estate location exposure to maximize potential growth opportunities. For instance, PPTYX’s geographic targets increase exposure to relatively attractive retail locations such as New York City, Washington, D.C., and Los Angeles. Moreover, the portfolio is significantly more diversified than market-cap weighted indices by reducing concentration risk among high-density urban areas like New York City and Boston.
Andrew Alden, Head of Quantitative Research for WeatherStorm Capital, broke down PPTY’s holdings to data centers 7.5%, diversified 7.5%, health care 7.5%, hotel 7.5%, industrials 14.%, manufactured home 2.0%, office 17.5%, residential 19.0%, retail 14.5%, self-storage 2.0% and student housing 0.5%. Additionally, he revealed the top geographic target allocations, including New York-Newark-Jersey City, NY-NJ-PA Metro Area 14.7%; Los Angeles-Long Beach-Anaheim, CA Metro Area 7.2%; and Washington-Arlington-Alexandria, DC-VA-MD-WV Metro Area 6.3%.
Financial advisors who are interested in learning more about the real estate sector can register for the Thursday, May 31 webcast here.