Looking for a cheap real-estate investment? You may have to search far and wide to find it.
The U.S. housing market is thriving again, with sales rebounding, landlords hiking rents and investors buying some properties sight unseen. The S&P 500 Homebuilding index has soared 74% in the past year and now trades at levels last seen in 2007. U.S. real estate investment trusts, or REITs, also look a bit “richly valued,” according to Eric Franco, a real estate portfolio manager with investment firm AllianceBernstein.
Looking overseas, though, Franco and other experts see some better bargains. Foreign real estate stocks trade at a discount to U.S. REITs, he says. Yields are higher abroad, and foreign real estate can help diversify a U.S. portfolio, making it less susceptible to a market downturn here at home.
"We view global real estate as more attractive and stable than a pure U.S. approach," he says.
Income and stability
REITs, which develop and manage properties from shopping malls to hotels and office parks, are required by IRS rules to pay at least 90% of their taxable income as dividends. They generally don’t grow as fast as homebuilders because they pay out most of their earnings. But they aren’t as volatile as builders and property development companies.
Moreover, REITs don’t move closely in line with U.S. stocks and bonds, especially if you include foreign real estate in the mix, says Daniel Joss, an adviser with Fox, Joss & Yankee in Reston, Va. Part of the reason is that demand for foreign office space, hotels and other properties may have scant connection to U.S. real estate trends.
“We think global REITs will do well for the long run,” says Joss, who recommends a 5% to 10% position in global REITs, depending on your tolerance for risk and time horizon.
Foreign REITs also look attractive in today’s market, says the fund manager Franco. Non-U.S. REITs yield 4.2%, according to the FTSE EPRA/NAREIT Global index, beating U.S. REIT yields averaging 3.8%. And non-U.S. REITs look cheaper with lower price-to-book and price-to-cash flow ratios, on average, he says.
Some advisers also like REITs for their potential to maintain their value if inflation increases. Property prices tend to rise with inflation, and REITs can boost rents as consumer prices climb, increasing their income and dividends. That can make them hold their value better than bonds and other fixed-income securities, which tend to fall when inflation picks up, says John Gjertsen, a financial adviser with D.L. Blain & Co., in New Bern, N.C.
Reasons for caution
While REITs may be thriving, they can still be risky.
The surge in prices over the last few years has pushed yields to historic lows. Compared to bond yields that are even lower, U.S. REITs still look attractive, according to Green Street Advisors, a real estate research firm in Newport Beach, Calif. But REITs look pricier when comparing their yields to the “earnings yield” of stocks. Indeed, REITs look 35% overvalued by that measure, according to the firm.
Though foreign REITs yield a bit more, they pose greater risks. Currency swings could wipe out returns for U.S. investors. Foreign markets may tumble due to local economic or political troubles, especially in developing countries such as China, which is trying to cool an inflated property market.
REITs are also sensitive to changes in long-term interest rates. Higher rates increase the costs of financing and reduce property values for REITs, according to Morningstar analyst Abby Woodham. While a gradual rise in rates may be manageable, REIT prices may come under pressure.
Investors may need to consider the tax implications of REITs too. REIT distributions are typically taxed at ordinary income rates, which can top 35% for high-income taxpayers. Funds that invest in foreign companies are also subject to foreign withholding taxes. If you hold the ETF in a taxable account, you can file for a tax reimbursement, notes Woodham. But foreign taxes can’t be recouped if the ETF is held in a tax-deferred account like an IRA.
One prudent strategy is to invest over weeks or months. That can lower your average cost and reduce the risk of buying before a market dip. It’s also important to consider what type of account to hold them in. As always, you should do your own research or consult an adviser before investing.
Global real estate ETFs and funds
Most ETFs and funds that invest in REITs also include real estate operating companies, which are more like traditional stocks. These companies develop and manage properties but they’re not required to pay a percentage of income as dividends. They tend to yield a bit less than REITs and be more volatile. The upside: They offer more growth potential, says Franco, and can help diversify a pure REIT portfolio.
One ETF to consider is the SPDR Dow Jones International Real Estate ETF (RWX). The $3.9 billion ETF tracks an index of real estate stocks in developed foreign markets, holding 32% in real estate operating companies. Top holdings include Japan's largest real estate company, Mitsui Fudosan (MTSFY), and Australian retail property developer Westfield Group (WEFIF).
The ETF is well-diversified, says the adviser Gjertsen, who uses it for clients. Its annualized yield, based on the recent share price, is around 6.2%.
The downside: The ETF has currency risk and its 22% exposure to Japan makes it susceptible to a downturn in the Japanese market. Its 0.59% annual expense ratio is above average for the category, according to Morningstar.
SPDR Dow Jones Global Real Estate ETF (RWO) is more of a pure play on REITs, which make up around 83% of the portfolio. It holds around half its assets in U.S. REITs, and it's the only large ETF that includes U.S. and foreign REITs in one package, notes Morningstar analyst Woodham. The ETF earns five stars from Morningstar, and it's been slightly less volatile than the global real estate category.
The downside: The annualized yield is relatively low at 3.7%.
Taking a more international approach, the iShares S&P Developed ex-U.S. Property Index ETF (WPS) holds about half its assets in REITs and half in real estate operating companies outside the U.S., making it one of the more balanced real estate ETFs. Morningstar analyst Abraham Bailin describes it as a "suitable" choice for most investors as part of a broader portfolio mix. The annualized dividend yield is 5.2%.
The downside: Around half its assets are in Hong Kong, Singapore and Japanese real estate stocks that can be quite volatile.
Among mutual funds, Invesco Global Real Estate Income (ASRIX) earns five stars from Morningstar. Over the last five years, it returned an average 5.9%, beating 99% of rivals.
While the fund holds around half its assets in the U.S., it ventures beyond traditional stocks with a third of the portfolio in preferred stocks and mortgage-backed securities. Those income securities help boost the yield, currently around 3.5%, and dampen volatility. Indeed, the fund has been about half as volatile as its benchmark index over the last three years, according to Invesco. And it sticks with developed markets, largely avoiding the more volatile developing world.
The downside: Preferred stocks and mortgage securities make the fund more sensitive to rising interest rates. It costs $75 to buy shares on the Fidelity platform.
Another fund with a strong record is Forward International Real Estate (FFIRX). Lead manager Michael McGowan is an industry veteran of 27 years, and his team looks for "quality" companies with growing cash flows and dividends in Asia, Europe and Canada. The fund surged 54% last year, and its older, institutional share class beat 99% of peers over the last three years with 17% average returns.
The fund now focuses heavily on the Asia-Pacific region, which make up 65% of its assets. McGowan and his team have been concentrating on small and mid-cap companies, and they're focusing on what they call "timeless cities"— major centers of global trade that are "magnets for commerce and population growth," according to a recent fund report.
The upshot: The fund bears scant resemblance to its benchmark index. Around 10% of the portfolio is in CSI Properties, a Chinese property development company that doesn't crack the top 10 in the index. Many of its other top holdings also fall outside the index's major positions. It currently yields 7.7%, according to Forward, based on the most recent annualized distribution rate and share price. The fund's distributions include dividends from stock positions, trading profits and income from foreign REITs.
The downside: The fund has had some rough years, including a 51.4% plunge in 2008, and it could be volatile going forward. Its focus on Asian markets could amplify losses if that region suffers a downturn. All its distributions over the last three years have been ordinary income, which is taxed higher than long-term capital gains, making the fund more suitable for a tax-deferred account.
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.