Re-balance Cycle Reminder All MyPlanIQ’s newsletters are archived here.

Regular AAC (Asset Allocation Composite), SAA and TAA portfolios are always rebalanced on the first trading day of a month. the next re-balance will be on Monday November 2, 2020.

Please note: As of March 1, 2020, we officially phased out our old rebalance calendar for both SAA and TAA. They are now always rebalanced on the first trading day of a month. 

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

REIT Indexes As Businesses

We continue our examination on stock indexes as businesses. This time, we look at Real Estate Investment Trusts (REIT) indexes.

Background of REITs

Real Estate Investments Trusts (REITs) are a special type of property owners and managers. They basically possess real estates or other hard assets that are similar to real estates (note:  strictly speaking, REITs also include Mortgage REITs that specializes mortgages for real estates, they don’t possess hard physical assets. In this newsletter, we focus on the other type of REITs: equity REITs that owns equity of physical real estates). They engage in renting these hard assets in order to derive regular income. They are thus more or less landlords of the hard assets.  

Based on NAREIT, the following are the common types of the equity REITs:

Industrial

Office

Retail
      Shopping Centers
      Regional Malls
      Free Standing
Residential
      Apartments
      Manufactured Homes
      Single Family Homes
Diversified
Lodging/Resorts
Health Care
Self Storage
Timber
Infrastructure
Data Centers
Specialty

 

The Data Centers REITs rent out physical space and some basic infrastructure such as power and cooling to companies to host servers and data storages. One of the largest data center REITs is Equinix. 

Specialty REITs include those that rent out telecommunication towers such as American Tower Corp or Crown Castle Intl Corp. Both Data Centers and Specialty REITs are the fastest growing REITs. 

In addition, MSCI US Investable REIT index tracked by Vanguard REIT index ETF (VNQ) or mutual fund (VGSIX) also include some real estate development companies. The following is the breakdown of the MSCI US index tracked by Vanguard REIT ETF VNQ as of 9/30/2020:

MSCI classifies data centers REITs as specialized REITs, which has the biggest weight (42%). The index characteristics and top 10 holdings: 

Other than PROLOGIS (industrial REITs), the other top six holdings are either data center REITs or telecom REITs. So when you look at an REIT index fund such as VNQ, in effect, it has a lot of exposure to these non-conventional ‘real estates’. 

The entire listed equity REIT (i.e. excluding private REITs not in the stock exchange) industry is about $1.1 to $1.2 trillion market cap. 

By law, REITs must payout at least 90% of their net earnings to shareholders as dividends. Of course, the net earnings are after expenses including employees’ compensation, interest payments and other overhead. 

REIT index as a business

Now, let’s take a look at an REIT index fund such as VNQ or VGSIX as a business. We view this as a conglomerate of REITs. For such a real estate conglomerate, the most important metrics include rental income and their financial structure. To measure regular income, a metric called FFO (Funds From Operations) is often used. FFO of an REIT company is defined as: 

FFO = Net Income + Depreciation + Amortization – Gains from Property Sales

FFO tries to measure the regular operating income by excluding depreciation/amortization (as net income already subtracts these two items so they are added back here to eliminate their effect) and irregular property sales. 

Like S&P 500 index companies, this conglomerate business has never had a negative quarterly FFO. This includes the severe financial downturn in 2008-2009 and the current pandemic periods: 

Quarterly FFOs since 2003 for all US listed equity REITs. Courtesy of REIT.com

In fact, even in the shutdown mode in the late Q1 and Q2 this year, this business’s FFO, though declined, is still very positive. 

For many individual real estate investors, another familiar metric is cap rate, defined as the ratio of annual rental income over market value of the properties. Let’s look at the cap rate of our REIT business (the whole US listed equity REITs:

Apparently, the cap rate has slowly declined since 2000 but it never dipped below 4%. So far, the cap rate is around 5%, certainly not great. Investors have bid up real estate prices (thus cap rate declines). On the other hand, this 5% or so cap rate is still relatively competitive, compared with the ultra low interest rates (for example, the recent 10 year Treasury note’s interest rate is about 0.77%). 

In the NAREIT’s document, readers can find other important data such as Debt to Assets, Interest Expense to Net Operating Income and weighted average term to maturity (when loans are due). In general, we find these numbers are reasonably sound. The business is solid by many important metrics. 

Reasonable long term returns

It turns out that REIT indexes have a very reasonably good long term total returns (dividend reinvested), comparable with stock indexes: 

As of 9/30/2020. REIT.com

So for the past 40 years, its annualized return 11.17% is a little bit lower than the S&P 500’s 11.43%. However, since 1972 (48 years), REITs’s 11.33% is actually higher than S&P’s 10.62%. In fact, based on the above table, their total returns are very comparable. 

To summarize, if you are a shareholder of an REIT index fund such as VNQ, USRT (iShares Core REIT Index ETF tracking NAREIT’s equity index like the one in the above) and SCHH (Schwab REIT index fund), you are essentially a fractional shareholder of owning diverse real estate operations in the US. These real estates (managed by professional companies) are generating some healthy rental income. Similar to holding a broad base stock index fund such as S&P 500 index fund SPY, your ‘properties’ have been able to generate inflation beating returns in a long term. 

Of course, just like in the stock index case, the definition of long term should be long enough: again, it should be 20 years or more to be able to get some reasonable returns. Furthermore, investing in a very good business doesn’t automatically guarantee a good long term return if your purchase price is very expensive. At the moment, one can see, from the above data, REITs are in general pricey. But in the next downturn when the cap rate reaches 6-10%, investors shouldn’t hesitate too much to scoop up this excellent ‘business’. 

Finally, we want to point out that market quotes of this business can fluctuates wildly, just like stock indexes. In fact, during 2008-2009 financial crisis, the maximum drop of VNQ from its peak to a trough is about 3/4 (73%). This is definitely not an investment for any period shorter than 10 years. Investors should fully understand the implication and for those who have shorter holding horizon, they should investigate and utilize a more dynamic or active strategy to invest in REITs. 

Market overview

We are aware that several important factors are emerging and greatly affecting financial markets:

  • We are now just two weeks from the US president election
  • The Covid19 pandemic US government stimulus is in its final negotiation phase
  • Increasingly, it looks like the pandemic is now in its second or third wave as winter is coming

Stocks will for sure experience some more volatility. As always, we should follow our strategies to navigate through this period:

  • For strategic allocation (buy and hold) investors, ignore the current market behavior. Remember, as what we have emphasized numerous times, when you choose and commit to a strategic portfolio, you essentially know and commit that your investment horizon (or the time you need to utilize this capital) is 20 years or longer. As we pointed out, if your investments are those diversified (index) funds such as an S&P 500 index fund (VFINX, for example), you know your money is in some solid ‘business’ that eventually (20 years later) will deliver some reasonable returns. As long as you are comfortable with this thesis, you should sit tight and forget about the current gyration.
  • For tactical investors, again, you have to ignore the current market noise. Furthermore, you should follow your strategy rigorously, especially in a time like this. Human emotion, both optimistic and pessimistic, and human desire, both greedy and fearful, are your worst enemies. This has been shown to be true time and time again.

Stock valuation now reached another high. For the moment, we believe it’s prudent to be cautious while riding on market uptrend. However how serious a correction might be, we have confidence in the US economy in the long term and thus in the stocks in aggregate. We just need to manage through interim losses carefully.  

We again would like to emphasize that for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

Enjoy Newsletter

How can we improve this newsletter? Please take our survey 

–Thanks to those who have already contributed — we appreciate it.

Latest Articles

Disclaimer:
Any investment in securities including mutual funds, ETFs, closed end funds, stocks and any other securities could lose money over any period of time. All investments involve risk. Losses may exceed the principal invested. Past performance is not an indicator of future performance. There is no guarantee for future results in your investment and any other actions based on the information provided on the website including, but not limited to, strategies, portfolios, articles, performance data and results of any tools. All rights are reserved and enforced. By accessing the website, you agree not to copy and redistribute the information provided herein without the explicit consent from MyPlanIQ.