Apartment Glut Keeps Residential Real Estate ETF In Check

by on October 7, 2009 | ETFs Mentioned:

In recent months, the U.S. housing market has shown signs of life, with several major metropolitan areas eking out small month-over-month gains. While home prices remain well below year-ago levels, there are at least signs that the worst has passed, and a modest recovery is now underway.

Apartment Buildings On Manhattan's  Lower East SideUnfortunately, the same can’t be said about the rest of the U.S. real estate market. Apartment vacancies recently surged to 7.8%, the highest level since 1986. And the rate is only expected to rise as demand drops further in the traditionally weak fall and winter months.

The decline in the rental apartment market is directly related to the unemployment rate, which recently climbed to 9.8%. As layoffs mount, the unemployed become more likely to move in with friends or family. The current environment has been particularly hard on landlords because a disproportionately high percentage of the unemployed are under the age of 35, the demographic most likely to rent.

While most REITs invest primarily in commercial and industrial real estate, they generally maintain moderate exposure to residential apartment buildings as well. The iShares FTSE NAREIT Residential Plus Capped Index Fund (REZ) invests more heavily in residential real estate, seeking to track the performance of the residential real estate, healthcare, and self-storage sectors of the U.S. equity market.

Expectations for a prolonged downturn in the rental real estate market have weighed on REZ, as the ETF has lost more than 25% over the last year. Even after this decline, there may be plenty of room for REZ to fall even further. Real estate firm Reis Inc. projects that the vacancy rate will peak above 8% in 2010. And while the record number of foreclosures over the last two years could lead some homeowners to move on to rental properties, a housing recovery could also lead the best quality renters to move out and purchase homes, writes Nick Timiraos.

With a price-to-earnings ratio of nearly 35 and a price-to-book ratio of nearly 1.9, REZ hardly seems like a value play, but next to other domestic real estate ETFs, it begins to look like a bargain.

Ticker ETF Price/Earnings Price/Book 30 Day SEC Yield 52 Week Return
REZ iShares FTSE NAREIT Residential Index Fund 34.8 1.9 5.0% -26.5%
IYR iShares Dow Jones U.S. Real Estate Index Fund 36.1 2.1 4.5% -21.5%
FTY iShares FTSE NAREIT Real Estate 50 Index Fund 37.1 2.1 4.7% -21.5%
FIO iShares FTSE NAREIT Industrial/Office Index Fund 43.4 1.3 3.9% -24.7%
IFGL iShares FTSE EPRA/NAREIT Global Real Estate ex-U.S. 23.2 1.5 0.3% 12.1%
WPS iShares S&P World ex-U.S. Property Index Fund 22.6 1.3 0.9% 13.7%

The above table highlights the significant discrepancy between domestic real estate fund and ex-U.S. ETFs. As U.S. real markets have struggled to find a market bottom, international real estate funds have recovered over the last year and started edging higher.

Part of the problem with domestic real estate ETFs may be the starting point for their decline. A bubble had formed under the U.S. real estate market prior to the financial crisis, making the correction more prolonged and severe than the downturns seen around the world. Many investors looking to gain exposure to real estate have begun looking beyond their borders to global real estate ETFs. Although the U.S. REIT market has rallied recently (gaining more than 30% in the third quarter), significant uncertainties remain, particularly surrounding the fate of commercial real estate.

Disclosure: No positions at time of writing.