Real estate ETFs that were riding high after a record high year of capital inflows in 2021 have seen the tide turn the other way with net outflows year-to-date in 2022 fueled by negative performance and broader market volatility. Despite these near-term headwinds, industry participants continue to believe the sector offers good opportunities for investors.
According to CFRA Research, real estate ETFs that welcomed $13.3 billion last year have since seen capital slip away with net outflows of $2.1 billion year-to-date through early June. Not surprising, real estate ETFs have been swept up in the sharp decline across the broader stock market. Many of the largest real estate ETFs that are down 20+ percent year-to-date as of mid-June.
“It has been a rollercoaster for real estate fund flows this year,” says David Auerbach, managing director of Armada ETF Advisors and portfolio manager of the Home Appreciation U.S. REIT ETF (HAUS). During first quarter, there was a bit of a frenzy into the markets based on coming out of COVID, while second quarter was the opposite with turmoil caused by high inflation and rising interest rates and the crisis in Russia and Ukraine.
“I think we have seen some investors move to the sidelines as they experience the ‘catch a falling knife’ type of market, but they are dabbling around quality names based on valuation or market strength,” says Auerbach. “I also believe that some investors are waiting for markets to stabilize, but it’s hard to see what catalyst will cause things to even out and get back to normal.”
Notably, a bulk of outflows across the roughly 60 real estate funds in the sector has been from a single passive ETF. According to CFRA Research, iShares US Real Estate ETF reported outflows of roughly $1.5 billion. The balance of real estate ETFs are reporting a mix of flows from negative or flat to continued positive levels. “On a slightly longer-term basis, the category has seen some nice growth with net flows of $17 billion for the three years ending May 31,” says Greg Kuhl, portfolio manager at Janus Henderson.
Buying opportunities ahead?
Given challenges in the market that include persistently high inflation, rising interest rates and fears of a recession, the third quarter could prove to be just as rocky as the second quarter. However, if the market sentiment shifts to one where the Federal Reserve is perceived to have a handle on inflation, then confidence could start returning to the markets, which could result in positive flows for the fourth quarter, notes Auerbach.
Investors typically like real estate ETFs as an investment vehicle that can deliver income, portfolio diversification and a potential hedge against inflation. For some, the downturn could present a buying opportunity. Many REITs saw a run-up in values in 2021 that have since dropped back. “I don’t think there is quite as much capital buying that dip as there was in the last couple of quarters, but there are those investors who do see this as a bargain opportunity,” says Alex Pettee of Hoya Capital. Hoya Capital has two real estate ETFs with its High Dividend Yield (RIET) and its Housing ETF (HOMZ). REIT fundamentals are very strong. On a pure multiple basis, REITs are as cheap as they’ve been since March of 2020, and before that, as cheap as they’ve been since 2013 or 2014, he adds.
Real estate ETFs also have been competing for investor capital with private vehicles, such as non-traded REITs, which have continued on their record fundraising pace in 2022. Non-traded REITs have traditionally touted greater stability because they are not subject to public market swings and holdings are not marked to market on a daily basis. However, non-traded REITs are reporting year-to-date returns of about 6 percent against real estate ETFs of -13 percent, notes Kuhl. “The underlying exposure of both non-traded REITs and real estate ETFs is commercial real estate that is very highly comparable. This means that either nontraded REITs will need to write down values, or that real estate ETFs are “on sale” by comparison,” he says.
Based on those metrics, Kuhl sees a scenario where investors could redeem out of their nontraded REIT holdings at 6 percent year-to-date and buy into effectively the same underlying assets via real estate ETFs at -13 percent year-to-date, capturing almost a 20 percent relative discount. “If this happens, it will result in more flows back into real estate ETFs,” he adds.
Evolving marketplace
Despite near-term hurdles, industry participants continue to remain optimistic about the fairly young sector and believe it is poised for further expansion. Real estate ETFs also are likely to benefit from the longer-term trend of investors shifting money from mutual funds to ETFs, which is still in the early stages. There is still roughly $150 to $200 billion in real estate mutual funds versus roughly $85 billion in real estate ETFs, estimates Pettee.
Although the current market is dominated by one giant player, there are a number of fairly new entrants that see opportunities to carve out a bigger foothold. Vanguard Real Estate ETF (VNQ) has roughly $41.5 billion in net assets in a total market with AUM that is currently around $85 billion. Schwab U.S. REIT ETF (SCHH) is a distant second at $6.3 billion.
“The real estate ETF market is heavily dominated by a few very large passive ETFs, which is part of the reason we’ve launched a vehicle in the space, as we believe there is ample room for a product aimed at investors who prefer a more targeted, forward-looking, ‘best ideas’ approach to commercial real estate,” says Kuhl. Janus Henderson launched its U.S. Real Estate ETF (JRE) in June 2021.
According to Kuhl, the median real estate ETF had returned, net of fees, about 5.5 percent annually on a three- and five-year basis ending May 31, 2022. “We find these longer-term historical returns underwhelming and they are another reason why we feel there is room for high-quality, actively-managed funds in this space,” he says.
In particular, investors seem to be gravitating towards a few key themes—income focused funds, actively managed funds and sector specific funds. “We also are seeing slow and steady growth in the more specialty products,” notes Pettee. “The key is to find that middle ground where it’s a unique enough strategy that it has that kind of interest and investment case to it, but it’s not so niche that the total investment marketplace is too small.” Given some of the current market challenges, it also is important for fund managers to have a good sales channel to reach a broader audience and be able to tell your story, he adds.
Managing expectations of investors in a rising interest rate environment poses another near-term challenge for fund managers. Conventional wisdom dictates that dividend-paying stocks such as REITs do not perform well during periods of rising interest rates. However, research shows that while REITs typically do have larger drawdowns at the onset of a rising rate cycle, they are quick to make up that ground and outperform general equities in subsequent quarters, notes Auerbach. “This is an important nuance and one of the reasons why investors should try and avoid reactionary responses in environments such as the one we are currently experiencing,” he says. “This said, not all property sectors will perform equally as markets begin to stabilize, and thus managers need to be hyper focused on fundamentals, valuation and balance sheet strength.”