Profiting From ‘Crazy’ High Rents With ETFs

There are plenty of ways to invest in real estate using exchange-traded funds.

sumit
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Senior ETF Analyst
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Reviewed by: Sumit Roy
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Edited by: Sumit Roy

Once ground-zero for the worst financial crisis in U.S. modern history, the housing sector has been a source of steady strength for the U.S. economy during the past few years.

Based on data from S&P/Case-Shiller, U.S. home prices are still down 5 percent from their 2006 peaks, but they’re up about 31 percent from their lows in 2012.

In the six months through July, home price growth has stabilized at around 5 percent year-over-year. That’s a solid pace, but well below the 15 percent-plus growth seen when the housing bubble was inflating in the years leading up to 2006.


S&P/Case-Shiller National Home Price Index


That’s not a bad thing. A more measured pace of growth is obviously preferable to a mania when it comes to the long-term health of the sector.

Home Construction Muted

Underpinning the strength in home prices has been the consistent rise in demand. Yesterday, the National Association of Realtors (NAR) reported that existing home sales in September rose by 8.8 percent from a year ago to an annualized 5.55 million unit rate. At the same time, supply has struggled to keep pace, with housing starts at historically low levels.


Lawrence Yun, NAR’s chief economist, points to several reasons for the tepid pace of homebuilding, particularly when it comes to single-family homes.


"There are many things holding back construction activity for owner-occupied housing," he said. Those include "difficulty of obtaining construction loans, difficulty of finding skilled construction workers, and local government officials approving only apartment buildings, but not condominium buildings."


Yun says that building activity levels for single-family homes are still at recessionary levels.

Rental Market Booming

In contrast to the residential homes, Yun says that building activity for multifamily units is above normal levels. One look at the rental market and it's easy to see why. Rents have been surging, with Svenja Gudell, chief economist at Zillow, calling them downright "crazy."


Renters now pay 30.2 percent of their income on rent, according to Zillow data, a record high. For comparison, homeowners only spend an average of 15.1 percent of their income on their mortgage.


Analysts are split on whether high rental prices will push more people into becoming home buyers. On the one hand, it may make sense from an affordability perspective. On the other, demographic trends suggest that the new generation, millennials, may be less inclined to buy, as they get married later in life and focus more on their careers.


The homeownership rate, currently at the lowest level since 1967—63.4 percent—could decline even more unless this trend reverses.

Homebuilder ETFs Jump

Clearly, the single-family and multifamily real estate sectors have very different fundamentals. For exchange-traded fund investors, both may offer opportunities for gains―but for different reasons.


When it comes to the single-family market, it's the homebuilder funds that offer the best exposure in an ETF wrapper. For example, the iShares U.S. Home Construction ETF (ITB | A-74) holds a market-cap-weighted basket of homebuilders and home improvement companies.


A rival fund, the SPDR S&P Homebuilders ETF (XHB | A-48), has an equal-weighted portfolio of companies in the homebuilding space, as well as firms involved in home improvement and appliances.

ITB is up 7.8 percent this year, while XHB is up 6.7 percent. Both have outpaced the broader market, which is up 1.3 percent based on the return of the SPDR S&P 500 (SPY | A-99).


YTD Returns For ITB, XHB, SPY

Demographic trends aside, there's plenty of room for these homebuilders to ratchet up construction activity just based on current demand. Moreover, if millennials eventually make the switch from renting to buying, that could spur a building boom that fuels more gains in the sector.


REITs Outperform

On the multifamily side, the simplest way to invest is through real estate investment trust (REIT) ETFs. REITs develop, own and operate real estate in a host of areas, generating income for investors through rents and price appreciation.


Yields on REITs are typically high, as they are required by law to pay out 90 percent of their taxable income as dividends to shareholders.


The iShares Residential Real Estate Capped ETF (REZ | B-79) is the top-performing real estate fund of the year, with a gain of 9.4 percent. However, the fund doesn't exclusively own companies in the multifamily (apartment) business. It also owns specialized REITs such as hotel, storage and health care REITs.


Aside from REZ, there are a dozen or so other REIT ETFs, including the behemoth in the space, the Vanguard REIT ETF (VNQ | A-88), which holds the entire U.S. publicly traded REIT universe. Residential REITs only make up 18.1 percent of VNQ's portfolio, with the rest primarily in commercial and specialized REITs. Year-to-date, VNQ has risen 3.5 percent.


YTD Returns For REZ, VNQ

Longer term, REIT ETFs have performed even more phenomenally, handily beating the returns for homebuilder ETFs as the rental business model outperforms.


VNQ is well above where it was trading during the last housing boom—in 2006—while a fund like ITB is still well below where it was.


Returns For VNQ, ITB, SPY Since May 2006

It remains to be seen whether REIT or homebuilder ETFs will outperform going forward, but both areas may find support as the U.S. economic expansion continues.

Mortgage REITs
It's worth pointing out another popular REIT fund, the iShares Mortgage Real Estate Capped ETF (REM | B-98). Unlike the equity REITs mentioned above, which own physical real estate, mortgage REITs own mortgage-backed securities. These REITs often employ leverage, attempting to capture the spread between short-term and long-term interest rates.


Mortgage REITs are essentially a carry trade, rather than a play on the real estate market per se. However, some investors like them for their extremely high yields. REM currently has a 30-day SEC yield of 11.2 percent.


Even so, the ETF has underperformed this year, with a 5 percent loss amid concerns about Fed interest-rate hikes. Higher short-term rates would push up the borrowing costs for mortgage REITs, reducing their income.

Interest-Rate Risk

Of course, rising rates are a risk that extends beyond just mortgage REITs, and to the housing market more broadly. If mortgage rates rise from current levels near 4 percent, that may deter potential homebuyers.

That said, NAR's Lawrence Yun is not too concerned about the impact from rising rates on housing demand: "Based on our stress test analysis, mortgage rates would have to go up to 6 percent to have a meaningful pullback [for] housing."


When it comes to equity REITs, the impact from potentially higher rates is not as clear-cut. Rising rates could be a boon for the already-strong demand for apartments. Additionally, if higher rates correspond with stronger economic growth, that could benefit commercial real estate.

On the flip side, as high-yield income-generating investments, REITs have a reputation as being negatively affected by higher rates. History suggests that that reputation is not completely warranted―REIT ETFs climbed during the last housing boom even as rates increased. Nevertheless, the relationship is something to pay attention to.


Contact Sumit Roy at [email protected].

Sumit Roy is the senior ETF analyst for etf.com, where he has worked for 13 years. He creates a variety of content for the platform, including news articles, analysis pieces, videos and podcasts.

Before joining etf.com, Sumit was the managing editor and commodities analyst for Hard Assets Investor. In those roles, he was responsible for most of the operations of HAI, a website dedicated to education about commodities investing.

Though he still closely follows the commodities beat, Sumit covers a much broader assortment of topics for etf.com, with a particular focus on stock and bond exchange-traded funds.

He is the host of etf.com’s Talk ETFs, a popular video series that features weekly interviews with thought leaders in the ETF industry. Sumit is also co-host of Exchange Traded Fridays, etf.com’s weekly podcast series.

He lives in the San Francisco Bay Area, where he enjoys climbing the city’s steep hills, playing chess and snowboarding in Lake Tahoe.