Real estate ETFs continue to attract attention from both investors and asset managers. As of September 30, there were 43 U.S. or global equity real estate ETFs managing $89 billion in assets, according to data from research firm CFRA. Year-to-date inflows of new capital amount to roughly $11.5 billion, while the sector also has added nearly a dozen new funds.
Hoya Capital Real Estate is one firm that is hoping to capitalize on investor demand for ETFs and high-yielding income products. The company recently launched its second ETF fund, Hoya Capital High Dividend Yield ETF (NYSE: RIET). No, that’s not a typo. The “i before e” highlights the fund’s income first strategy. RIET expects to pay monthly distributions. As of August 31st, RIET was delivering an index yield of 6.7 percent, which is twice the dividend yield of the FTSE Nareit All REIT Index of 3.2 percent as of Oct. 8th.
WMRE recently talked with Alex Pettee, CFA, president and director of Research & ETFs at Hoya Capital Real Estate to hear more about the fund’s strategy and where he’s finding yield in the current market.
This interview has been edited for style, length and clarity.
WMRE: It seems as though investor demand for high-yield investment products is greater than ever. What do you think is driving that?
Alex Pettee: From our vantage point, the need and demand for portfolio income hasn’t changed over the years. It simply takes more work—and some extra creativity—to achieve sufficient yield in a world of “zero interest rates” on risk-free securities. Yields have compressed across all asset classes over the last several decades, but particularly in the bond markets where it’s tough to find mid-single-digit yields without taking on quite a bit of risk. And it’s all but impossible to find that type of mid-single-digit yield over in the traditional equity markets.
Thankfully, there’s still plenty of yield to be had in the real estate sector, which tends to get overlooked by many investors for one reason or another, particularly the mid-cap and small-cap REITs that really fly under the radar. Surveys of institutional asset managers show that REITs continue to be under-owned among active portfolio managers but have a history of over-delivering.
WMRE: RIET is designed to provide diversified exposure to 100 of the highest dividend-yield real estate securities. Is it more heavily weighted to certain sectors or property types than others?
Alex Pettee: Not unlike the broader equity market, real estate is an enormous asset class with a distinct mix of higher-yield and higher-growth property sectors, and within those property sectors, there’s typically a mix between REITs focused more on longer-term growth and those focused on returning capital to shareholders. Among the roughly 220 U.S. exchange-listed REITs—the majority of which are mid-caps and small-caps, the average dividend yield is around 4.5 percent—and that’s just on the common stocks. When you include the universe of REIT preferred stock as well, the average yield jumps to nearly 6 percent.
However, not unlike what you’re seeing in other benchmark indexes like the S&P 500, market-cap-weighted REIT indexes have become increasingly dominated by a handful of mega-cap—and low-yielding—technology names, which drag that average yield down closer to 3 percent. While names like American Tower, Crown Castle and Equinix have been strong performers in recent years, investors that simply need the income yield are finding it increasingly difficult to find in the cap-weighted real estate indexes.
Consistent with the “income first” theme of the fund, the index selection rules in RIET prioritize the property sectors—and REITs within those sectors, that tilt towards the higher-yield side of the yield/growth spectrum. So put simply, RIET achieves its premium yield by ditching the constraints of the market-cap-weighted structure and instead uses the rules-driven process to exclusively target the income-side of the real estate sector. Specifically, the RIET selection process begins by selecting "Dividend Champions" using a quality screen to identify REITs with lower leverage. Dividend-paying common and preferred stocks issued by U.S. listed REITs—100 in total—are then selected based primarily on dividend yield, subject to diversification requirements across property sectors and market capitalization tiers.
WMRE: What property sectors or companies are delivering the highest yields right now?
Alex Pettee: The highest-yielding property sectors—and by extension the higher sector weights in RIET, will vary over time. But, since yield and value are closely correlated within the REIT sector, naturally the more value-oriented REIT sectors tend to be the higher-yielders. Currently, the sectors with the highest yields include sectors like the commercial financing and home financing REITs which were hit hard early in the pandemic by the volatility in the interest rate markets but have staged a strong recovery this year. Similar themes apply to other high-yielding REIT sectors like healthcare and retail, most of which have seen fundamentals stabilize and dividend distribution return to pre-pandemic levels in recent quarters following a rough 2020.
In the index design process, we focused on how the different market environments affected the property sector-weights and the diversification rules that we implement in the index—capping the number of REITs per property sector—was the result of the findings of this process. Without these types of rules, you often see situations where the fund is extremely overweight in a handful of property sectors. We ran simulations of different market environments, both historical and theoretical, to see the impact on the performance and composition of the index. Specifically, we were looking to see how different rules affected its variance from the broad-based REIT benchmarks, as the ultimate goal is not necessarily absolute performance, but rather to give investors a higher-yield version of the REIT exposure that they’re already familiar with and the risk level that's understood.
WMRE: Higher yields are often associated with higher risk. Is that the case here?
Alex Pettee: This fund leans heavily on the risk-mitigating benefits of diversification through the rules-based process. With 100 components in the tiered equity weight system, and with no single component above 1.5 percent, you remove a lot of the company-specific risk. Then you layer in the property sector categorization, which limits the exposure to sector-specific risks—retail, office, etcetera—and the market-cap categorization, all of which are factors that we’ve researched extensively specifically within the confines of the REIT universe.
The result is a level of risk control that we’re quite comfortable with based on extensive back-testing and scenario analysis, while at the same time, achieving a premium dividend yield relative to the market-cap-weighted REIT indexes. Of course, investing in 100 stocks within one’s real estate allocation would be extremely challenging and time-consuming at the individual portfolio level, but with the scale of the ETF, we’re able to do it with a high degree of efficiency. And it’s interesting because you see a lot of other products out there that don’t really maximize this benefit of the fund wrapper, in my personal opinion as both an investor in these indexes and a REIT and ETF analyst.
You look at other dividend-focused real estate products that have just 30 stocks or the market-cap-weighted indexes in which the top 10 holdings are just 40 to 60 percent of the fund, and I think you lose a lot of the core benefit of the ETF model—the efficient diversification. So in short, we created RIET to address a need of our own clients, and by extension, the need of many investors seeking income in a diversified turn-key package.
WMRE: Currently, there are a few dozen REIT ETFs, some sponsored by big names ike Vanguard and Blackrock. What’s your strategy for attracting investors?
Alex Pettee: I think that the early success of our first fund, HOMZ, confirms our belief that investors recognize the value of investing alongside a specialist in the real estate industry and in high-conviction concepts that are supported by research and fundamentals. Real estate is our focus 24/7/365, and with more than 200 individual REITs across more than a dozen property sectors—many of which have multiple classes of stock—the sector really does require a dedicated focus.
I think that investors are increasingly seeing the inherent shortfalls of the simple market-cap-weighted approach in the real estate sector, particularly for investors seeking income. Cell towers, for instance, represent up to 20 percent of some of the cap-weighted indexes even though the total value of towers is only about 1 percent of the total U.S. real estate market. Regardless of one’s outlook for that sector, by investing in cap-weighted indexes, there’s an inherent active bet on factors that have little to do with fundamentals, and more to do with somewhat random dynamics.
So, our strategy continues to lean heavily on investor education, research and transparency. We’ve published hundreds of research reports and white papers about the real estate sector and have built-up an audience through this platform.
WMRE: What’s your outlook for continued growth in the real estate ETF space and why?
Alex Pettee: From out vantage point, the real estate ETF marketplace is only in the second or third inning, which is even earlier in the life cycle than the broader ETF industry, which I would say is closer to the fifth inning. Despite the significant inflows into real estate ETFs from relatively higher-fee and less tax-efficient mutual funds and closed end funds, ETFs still represent just a small slice, roughly a quarter by our estimates, of the total invested assets in real estate funds.
And within that quarter, the vast majority of investors still use the traditional market-cap-weighted products that, in my view, aren’t fully aligned with the actual investment objectives of many investors in real estate sector, particularly those seeking income. But I think you’ve started to see the beginning of some excellent innovation in the real estate ETF marketplace over the last half-decade, including with the sub-sector-focused products offered by the teams at Benchmark and Fundamental Income, which are again in response to some of the shortfalls of the cap-weighted approach.
I think you’re also seeing a broader “institutionalization” of U.S. real estate markets, which over time will result in a higher share of assets owned by publicly-traded entities. You see that most prominently in the single-family rental sector, but even there institutional investors like REITs still own just two to three percent of single family homes. These trends are overall net positives, as REITs have always been pioneers in the democratization of real estate investing and tend to be leaders when it comes to tenant customer service and corporate governance.
So, we’re extremely optimistic on the overall outlook for the real estate sector and our corner of the marketplace in the ETF world. We’ve been encouraged to see over 110 REITs raise their dividends this year—the most ever through three quarters of the year, which has underscored the point that the sector appears to now be stronger than it was pre-pandemic.