Residential REITs Offer Steady Dividends With Long-Term Growth Potential
Summary REZ is a well-diversified ETF with both moderate long term growth potential and a 3.3% dividend yield, making it a great income play. REZ has ~49% of its holdings in residential REITs, which are expected to experience steady demand over the next few years as renting becomes more and more attractive. REZ also has ~29% of its holdings in healthcare REITs, which are primarily composed of different types of senior housing. As baby boomers retire, demand here is expected to skyrocket. Finally, REZ has ~22% of its holdings in self-storage REITs, a booming industry of late. They tend to follow economic trends, so I’m bullish on self-storage REITs as well. The potential risk posed to REITs from an interest rate hike is not to be ignored, as it increases the cost of financing new projects. The iShares Residential Real Estate Capped ETF (NYSEARCA: REZ ) is a popular ETF for those who wish to invest in US residential real estate without actually being a landlord. It does this by using the FTSE NAREIT All-Residential Capped Index as its benchmark index, which is comprised of many different REITs. Taking into account demographic changes, a trend towards renting instead of buying and a recovering economy, I’m bullish REZ in the long term. I view it as a great income play with moderate long-term growth potential as well. REZ Overview Offering an attractive dividend yield of 3.3% and a tolerable expense ratio of 0.48%, this ETF has been popular with investors since its inception in May 2007. It currently has about $316MM in assets. REZ can generally be looked at as holding 3 different types of REITs. The first are obviously residential REITs, which develop multifamily housing such as apartment complexes. The second are healthcare REITs, which can generally be categorized as senior housing. The third are self-storage REITs. (click to enlarge) (Source: Data for chart by iShares.com ) To find the holdings for the chart above, I went through each individual holding and categorized it as self-storage, healthcare or residential. Some that I categorized as residential may have been categorized by iShares as specialty. Due to this, my percentages are about 2% off of iShares own classification, which is between residential, healthcare or “specialty” (which I felt was too broad). As you can see, while traditional residential REITs make up 49% of this ETF, there are still significant investments in self-storage and healthcare REITs. Due to this, one has to consider many more factors than just the residential housing market when considering investing in REZ. I’ll be reviewing the outlook for all 3 of the different types of REITs in this article. Residential REITs Outlook Housing prices are just below record highs, but this time it’s not thought to be a bubble , as strong economic growth has fueled increasingly higher housing prices. This is very bullish for residential REITs, as more and more people are resorting to renting. Mortgage requirements are tighter, making it more difficult for lenders to make loans than it was pre-2008. This coupled with slow wage growth makes buying a home less feasible for many people. Additionally, new US housing starts are very low, with these high prices simply mirroring the scarcity of supply. As you can see below, builders still haven’t recovered from the recession. (Source: tradingeconomics.com ) When adjusted for inflation, housing prices are just below record highs, according to the census . The rate at which housing prices have increased has also remained at a respectable level into these highs as well. (click to enlarge) (Source: Data by S&P Dow Jones Indices) Keith Gumbinger, VP of HSH.com, dismissed the idea that a bubble is forming, stating that “Today’s rising prices are fueled by actual market forces, backed up by real money.” This couldn’t be more true in my opinion, and many economists do not believe a bubble is forming either. All of these factors, which make buying a home less and less realistic are very bullish for residential REITs, as people will naturally resort to renting. As you can see in the chart below, the trend has clearly been in favor of renting the last 5 years. The US rental vacancy rate is currently reaching lows not seen since 1985. (Source: US Rental Vacancy Rate data by YCharts) It’s thought that housing prices will continue to increase, albeit at a slower rate than they have in the past few years. I don’t see the vacancy rate significantly rising again either. So with housing prices expected to continually grow, the only risk I can see to this REIT category is the potentially negative effect an interest rate hike could have. This investment is not without its risks though, as higher interest rates increase the cost of financing the balance sheet. This makes projects more expensive for REITs, which depend heavily on debt to finance new projects. Some would disagree that an interest rate hike is net bearish for REITs, saying that increased economic growth and occupancy rates are closely linked to the performance of REITs. They say that once everything is factored in, REITs will come out at a net gain due to increased occupancy rates and inflation. So while the net affect of an interest rate hike isn’t clear, I’d recommend those interested in REZ conduct their own due diligence to decide for themselves. Healthcare REITs Outlook Healthcare REITs make up 29% of REZ’s holdings and are very well positioned to take advantage of the massive impending demographic changes in the United States. The “Baby Boomer” generation is aging, with about 10,000 turning 65 every day . As this segment of the population begins to age, healthcare REITs owning senior housing facilities will see a huge and steady surge in demand. (Source: FiveThirtyEight.com ) Investments in healthcare REITs are a long-term strategy though, so I wouldn’t recommend this ETF to medium-term investors, as nearly a third of REZ’s holdings are in healthcare REITs. As a 2005 study by Stefano DellaVigna and Joshua Pollet found one needs to wait 5-10 years before fully reaping the benefits that demographic changes bring to businesses. I think this finding applies best to healthcare REITs in the current environment. With many of them having been beaten down over the last couple years, there is serious growth potential to go along with the handsome dividends these REITs offer to those who are patient. So for those willing to wait, I view this segment of REZ bullishly in the long term. Self Storage REITs Outlook Self storage REITs, which make up about 22% of REZ’s holdings, have exploded over the last few years in both share price and popularity. With average occupancy rates around 90% and a business that tends to reflect economic trends, there are plenty of reasons to be bullish here. These REITs are extremely profitable as well. REZ’s largest self-storage holding (12% of assets), PSA, had a net profit margin of 52% last year. Most self-storage REITs have performed very well over the past few years as well, showing the sector has growth potential in addition to respectable dividends. I expect demand to grow with the economy as well, so I have a favorable long-term outlook for these REITs. (click to enlarge) (Source: San Clemente Self Storage ) I expect demand for these self-storage units to go hand in hand with demand for rental housing as well. An article by the CCIM institute noted that about 30% of the average property’s customer base lives in apartments and about 13% live in townhomes/condos. These higher housing prices are driving more people to renting or downsizing, increasing demand as they’ll need more room to store all of their “stuff.” It’s worth noting though that self-storage REITs see increased competition compared to many other types of REITs, as the vast majority of self-storage facilities are owned by local entrepreneurs. Back in 2000, REITs made up less than 10% of new development. While that was a long time ago, I expect that local entrepreneurs still maintain ownership of a sizable portion of self storage facilities. Some of the more profitable facilities are being acquired by REITs, but the large amount of locally owned facilities puts increased competitive pressure on REIT-owned facilities. In general though, I view self-storage REITs very bullishly in the medium term to long term. REZ: A Great Income Play With Long-Term Growth Potential After a thorough review, one can see that this ETF is well-diversified into many more sectors than purely residential REITs, as the name suggests. In my opinion, REZ would be a great addition to the portfolio of a long-term income investor who is interested in taking on a little bit more risk in exchange for moderate growth potential. The 3.3% dividend offers a great opportunity for steady income just as owning physical real estate would, but with much greater liquidity. In addition to the dividend, it offers a moderate growth opportunity to more aggressive income investors who believe housing prices are going to rise and want to take advantage of the drastic demographic changes taking place. I believe each of the 3 primary types of REITs that REZ holds will grow with the economy over the next decade. This investment is not without its risks though, so when considering an investment in REZ, one should weigh the immediate negative affect an interest rate hike could have with the dividends and long-term growth potential. I wouldn’t recommend investors use REZ as their primary income source, as the trend towards renting may change over time, which could have an adverse affect on share prices and dividend payments. Overall though, I think the factors mentioned above would make REZ a great portfolio addition for long-term growth investors who want their portfolio to generate additional income, as well as purely income investors who want to pursue moderate growth while not giving up their income stream. Conclusion REZ is a well-diversified ETF that is much more than simply a residential REIT. There are many factors one needs to account for and many different markets that one should research. From a fundamental perspective, though, I view each of the 3 primary REIT types that REZ holds bullishly in the long term. I think that long-term investors who believe that growth and income investing don’t have to be mutually exclusive could benefit greatly from this ETF. I think that long-term investors who are patient will see their diligence handsomely rewarded through steady dividend payments and moderate growth.