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Is the Worst over for Real Estate?

Is the Worst over for Real Estate?
Ron DeLegge
April 12, 2010

SAN DIEGO (ETFguide.com) – Where’s the long-awaited crisis in commercial real estate and when will it arrive?

During the first quarter, U.S. based real estate investment trusts (REITs) roared ahead by 9.57% easily outperforming the S&P 500 (NYSEArca: SPY) which posted a 5.39% gain.

A glut in commercial real estate is still present in many local markets, but signs of improvement are already being reflected in rising real estate shares.

REITs are publicly traded companies that invest in real estate and investors have traditionally flocked to REITs for dividends.

Alex Goldfarb, a REIT analyst with Sandler O'Neill and Partners attributed the strong performance of REITs to cap rate compression and tightening credit spreads. Goldfarb also observed that widespread distressed sales have failed to materialize and that increasing demand has moved institutions to re-embrace REITs.

To be qualified as a REIT under IRS guidelines, a company must invest at least 75 percent of total assets in real estate; derive at least 75 percent of gross income as rents from real property or interest from mortgages on real property; and make annual distributions of at least 90 percent of taxable income in the form of shareholder dividends.

Let’s analyze some of the key real estate ETFs:

iShares FTSE NAREIT Residential Real Estate (NYSEArca: REZ)
According to Reis, the apartment vacancy rate remains stubbornly high at 8% but was offset by rising rents during the first quarter. Despite low mortgage rates and more affordable home price, more people are renting. Nationwide unemployment has been a major contributing factor to this trend.

REZ consists mainly of property stocks primarily involved in apartments (45.30%), health care (36.94%) and public storage (14.13%). Through the April 8th market close, REZ has been a strong performer, rising 11.17%. The fund contains 33 holdings and it charges annual expenses of 0.48%. 

iShares FTSE NAREIT Industrial/Office Index Fund (NYSEArca: FIO)
So far this year, FIO has risen around 9.75% and the commercial real estate market continues to heal itself. Top holdings inside FIO are Boston Properties, Prologis, Duke Realty and other office/commercial property companies. According to Reis, office rents during the first quarter stabilized. Landlords have sharply reduced rents too, which explains one reason why office vacancies were virtually flat during Q1.

FIO contains 27 holdings and it charges annual expenses of 0.48%. 

SPDR Dow Jones International Real Estate ETF (NYSEArca: RWX)
RWX is linked to the performance of the Dow Jones Global ex-U.S. Select Real Estate Securities Index.  The index contains around 130 stocks, with Australia, Japan and the United Kingdom being the largest country representatives.  RWX is ex-US, meaning it contains no exposure to US real estate stocks.

So far this year, RWX is ahead by 2.55% and it carries a dividend yield of around 4%. The fund charges annual expenses of 0.59%.

Vanguard REIT ETF (NYSEArca: VNQ)
VNQ is one of the broadest measures of the U.S. REIT marketplace. It follows the MSCI US REIT index, which has almost 100 holdings.

VNQ carries a dividend yield around 3.80%. The fund is ahead by roughly 13% on the year and it charges annual expenses of 0.15%.

Leveraged Long/Short Real Estate ETFs
Daily leveraged 2x and 3x long ETFs linked to real estate indexes like (NYSEArca: URE) and (NYSEArca: FAS) have soared ahead with rebounding shares. Year-to-date gains are in the 20-30% range.

Conversely, 2x and 3x daily leveraged inverse ETFs benchmarked to real estate indexes like (NYSEArca: SRS) and (NYSEArca: DRV) have performed poorly this year with losses in the 20-30% range.

Conclusion
Highly regarded individuals in the investment community like David Swensen, manager of Yale University’s endowment, advocate market exposure to real estate through thick and thin. In his book Unconventional Success: A Fundamental Approach to Personal Investment (Free Press 2005) he recommends a 20 percent allocation to real estate in a diversified investment portfolio. Individuals that own income properties or have large real estate holdings may decide to reduce exposure to REITs or skip them altogether.  

What's ahead for the real estate sector? While it’s far from certain if the worst is over for real estate, having low cost exposure via an index fund or ETF can compliment a portfolio by adding further diversification. As we learned during the 2008 crisis, individual stocks and companies can evaporate, but sectors never die.  

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