VNQ: Buy REITs As Tailwinds Mount In 2024 (2024)

VNQ: Buy REITs As Tailwinds Mount In 2024 (1)

Will Rogers once said, “don’t wait to buy real estate, buy real estate and wait.” It is a great quote that highlights the importance of diligence in long term investing. Life rarely presents an opportunity to buy the highest quality assets at a reasonable price. However, 2024 is poised to be a rebound year for real estate as tailwinds continue to mount for the sector. Today, there is significant value across the real estate sector and investors have bountiful opportunity to capitalize. We are going to explore a simple but effective way to take advantage of opportunities in the commercial real estate sector.

REITs have been beaten down by rising interest rates and a flight to income producing alternatives such as bonds. For more than a decade coming out of the financial crisis, REITs benefitted from a low interest rate environment which facilitated a long-term decline in capitalization rates. The decline in initial yield was accelerated by low costs of capital for landlords and developers, incentivizing aggressive growth across the sector. Additionally, low rates drew attention to REITs as an income producing alternative where investors could access yield supported by strong assets and corporate credit. As a result, REITs performed well over that period.

VNQ: Buy REITs As Tailwinds Mount In 2024 (2)

VNQ: Buy REITs As Tailwinds Mount In 2024 (3)

The “Goldilocks” environment came to a screeching halt in 2022 as rapid increases in interest rates shaped a series of headwinds for real estate. Increasing borrowing costs halted acquisitions and new development. Inflation injected uncertainty around labor and material costs which added to the risk factors. Investors reallocated capital as bond yields surged and offered an opportunity for a higher return with less risk. The REIT market rapidly adjusted in a chaotic fashion creating pricing discrepancies, which we will explore.

The Opportunity

Chaos breeds opportunity. The real estate turmoil over the past two years has caused real estate investors and asset managers to diverge from their traditional playbooks. Low interest rates had the market in agreement regarding pricing because ample transactions across the world supported harmony between public and private valuations. This important connection was one of the first to deteriorate as interest rates rose. Transaction volume decreased significantly as interest rates increased, leaving little support for valuations.

Publicly traded REITs saw worse performance during the initial turmoil due to their liquidity. Private funds have limitations outlined in their prospectus which specify a maximum amount of NAV that can be redeemed within a quarter. In contrast, public REITs trade independently of NAV causing their implied capitalization rates to move freely. As investors sold REITs to pursue other assets, public REITs were heavily impacted while private real estate funds were able to protect their assets by limiting redemptions. Reality is beginning to set in as funds continue to dispose of assets to cover mounting redemption requests. For example, Blackstone’s (BX) flagship real estate fund recently posted its worst annual performance since inception. Redemptions in the fund remain high as Blackstone indicates an additional $1.1 billion in requested redemptions in December.

Currently, the difference between appraisal valuation of private funds and the implied capitalization rates of their publicly traded competitors remains significant. In the fourth quarter of 2021, the spread between public and private REITs was 0.83%. In the third quarter of 2023, this spread had more than doubled to 2.16%. NAREIT further specified that in the third quarter, the spread between implied capitalization rates and private transactions was 1.70%. The difference in valuations implies a discrepancy of approximately 30% at the property level. The consensus suggests a convergence of these valuations as investors capitalize on the arbitrage opportunity.

If the Federal Reserve lowers interest rates, REIT valuations will expand, and public REITs will offer a vehicle to capitalize on the opportunity. Sector performance accelerated significantly in the fourth quarter as investors concluded that interest rates have at least leveled off. NAREIT’s annual report was thoroughly optimistic that 2024 will be a rebound year for the REIT sector.

As we look ahead to 2024, the high interest rate environment will likely continue to broadly impact both commercial real estate and REITs. The rapidly emerging consensus is that the Federal Reserve is entering a new, more accommodative period that increases the prospects for stabilizing and even declining interest rates.

Even in this new phase of monetary policy, the current high level of interest rates will continue to affect CRE. Nevertheless, we are cautiously optimistic that despite those challenges, the REIT recovery could begin next year. The impressive performance of REITs during late October and November may be a signal that, as in previous periods of monetary policy adjustments, the end of the rate-rising cycle will herald a period of REIT outperformance.

Source: NAREIT

NAREIT appears to have been correct as REITs pummeled the Russell 1000 between October 19th and year-end. Sector performance should continue to hold if the optimistic thesis around interest rate movements pans out. One of the best ways to capitalize on sector tailwinds is a broad market exchange traded fund. We have covered the Vanguard Real Estate Index Fund ETF (NYSEARCA:VNQ) before, exploring how the fund is one of the most cost efficient options to access REITs. So let’s dive in once again and explore why VNQ is a superior REIT ETF.

Why VNQ?

VNQ is one of the oldest REIT ETFs and is managed by one of the largest asset managers. There are a variety of REIT ETFs available from both Vanguard and other options such as BlackRock (BLK). The nuance between funds usually lies in their underlying index. VNQ’s index encompasses the widest approach of all competing funds, including most of the real estate market in its entirety. VNQ follows the MSCI US Investable Market Real Estate 20/50 Index

The MSCI US IMI Real Estate 25/50 Index is designed to capture the large, mid and small cap segments of the U.S. equity universe. All securities in the index are classified in the Real Estate sector as per the Global Industry Classification Standard (GICS®). The index also applies certain investment limits to help ensure diversification--limits that are imposed on regulated investment companies, or RICs, under the current US Internal Revenue Code.

Source: MSCI

The fund is widely diversified across REIT subsectors, encompassing most public REITs. Additionally, as an index fund, VNQ follows its benchmark closely with little deviation. The largest subsectors of VNQ are industrial REITs, led by Prologis (PLD), telecom tower REITs, led by American Tower Corporation (AMT), and retail REITs, led by Simon Property Group (SPG). The top investments in VNQ’s portfolio are the largest and most established public landlords.

VNQ: Buy REITs As Tailwinds Mount In 2024 (7)

There are a variety of reasons to love VNQ such as the fund’s liquidity. VNQ remains one of the most traded real estate ETFs, outpacing other competitors by a significant margin. While immaterial for some investors, liquidity in a fund remains important especially during tumultuous times where price action can vary more significantly. Additionally, VNQ offers options trading, giving investors an additional opportunity to speculate against macroeconomic trends impacting the real estate market. Shareholders can generate additional yield by writing covered calls against VNQ to supplement the quarterly dividend generated by the fund.

While investing in individual REITs offers an opportunity to outperform the index, many long term investors want to remove the guesswork from the equation. VNQ’s cost efficient approach offers a low-risk vehicle to invest in a diversified portfolio of high quality real estate assets. For investors seeking to “buy real estate and wait”, as Will Rogers suggested, VNQ is a perfect investment to buy and never look back. The fund is well supported by healthy trading volume, a heavily diversified portfolio, and a world class asset manager.

Conclusion

REIT tailwinds are mounting in 2024. Falling interest rates, shrinking valuation gaps, and accelerating transaction volume lay the foundation for a continued rally through the year. Time is of the essence as macroeconomic trends begin to align and support a real estate rebound. VNQ presents an opportunity to take the guesswork out of real estate and diversify your investment across the market. When capitalizing on a macroeconomic opportunity such as valuation discrepancies and interest rate movements, accessing the market is generally a wise decision.

This article was written by

REITer's Digest

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I am a real estate professional with nearly a decade of experience across valuation, research, and portfolio acquisitions. Having spent my career with a big four firm and an S&P500 real estate investment trust, I am intimately familiar with the public real estate markets and REIT analysis. I created REITer’s Digest to share my thoughts and expertise on real estate, REITs, and fundamental investing concepts to help investors make informed decisions.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of VNQ, PLD either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

I am a seasoned real estate professional with nearly a decade of experience spanning valuation, research, and portfolio acquisitions. My career includes significant time with a big four firm and an S&P500 real estate investment trust, providing me with an intimate understanding of the public real estate markets and comprehensive REIT analysis. I've established REITer’s Digest as a platform to share my insights and expertise on real estate, REITs, and fundamental investing concepts, aiming to empower investors in making informed decisions.

In light of the article you provided, it's evident that the author is well-versed in the dynamics of the real estate market, particularly focusing on Real Estate Investment Trusts (REITs) and the broader commercial real estate sector. Let's break down the key concepts used in the article:

  1. Will Rogers Quote: The author starts with a quote from Will Rogers, emphasizing the importance of taking action in real estate and being patient for long-term gains. This sets the tone for the article, highlighting the significance of diligence in long-term investing.

  2. REITs (Real Estate Investment Trusts): The article discusses the impact of rising interest rates and a shift towards alternative income-producing investments on REITs. It provides a historical perspective, noting the favorable environment for REITs post-financial crisis and the challenges they faced in 2022 due to increasing interest rates.

  3. Goldilocks Environment: Refers to an ideal economic environment with steady growth and low inflation, which was disrupted by rapid increases in interest rates in 2022, impacting the real estate market.

  4. Pricing Discrepancies: The article suggests that the chaos in the real estate market created pricing discrepancies between publicly traded REITs and private funds. Publicly traded REITs were more heavily impacted due to liquidity issues.

  5. Implied Capitalization Rates: The difference between appraisal valuation of private funds and the implied capitalization rates of publicly traded REITs is highlighted, indicating a significant spread and potential arbitrage opportunities.

  6. VNQ (Vanguard Real Estate Index Fund ETF): The article recommends VNQ as a superior REIT ETF. It emphasizes VNQ's wide diversification across REIT subsectors, its liquidity, and cost-efficient approach. The underlying index, MSCI US Investable Market Real Estate 20/50 Index, is discussed.

  7. Market Outlook for 2024: The author expresses optimism about the rebound of the REIT sector in 2024, anticipating falling interest rates, shrinking valuation gaps, and increasing transaction volume.

  8. Conclusion and Disclosure: The conclusion reiterates the opportunity presented by REIT tailwinds in 2024 and emphasizes VNQ as a strategic investment choice. The author discloses their beneficial long position in VNQ, PLD, and asserts that the article reflects their personal opinions.

In summary, the author effectively combines historical context, market analysis, and a specific investment recommendation to guide readers through the complexities of the real estate market and potential opportunities in the REIT sector.

VNQ: Buy REITs As Tailwinds Mount In 2024 (2024)

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