What’s Driving The Real Estate ETF (VNQ)?

by on May 4, 2010

After more than almost 14 months of a relatively stable recovery effort, many equity ETFs have climbed to within shouting distance of their pre-recession highs, as consumers have regained their swagger and companies are once again delivering solid earnings reports. Even the sectors that were closest to the economic implosion in late 2008 are showing signs of strength. Despite concerns over the potential regulatory impact, financials ETFs have been among the best performing sector ETFs to date in 2010. And real estate ETFs, some of which lost nearly 70% of their value in less than six months, have surged as well (see ETFs Claw Back To Pre-Recession Levels).

Once seen as a critical component of any well-diversified portfolio, some investors have abandoned real estate as an asset class following its dismal performance during the recent economic collapse and strong correlation with domestic and international equities. But those who stuck with their real estate investments through the turmoil have been rewarded in 2010, as many of the ETFs in the Real Estate ETFdb Category have been among the year’s best performers. The Vanguard Real Estate ETF (VNQ), the largest fund in the category, has gained almost 10% since the middle of April, shooting higher as a number of positive developments have combined to give a major boost.

So what’s driving this impressive run-up in an asset class many investors now consider excessively risky? There are a number of contributing factors, three of which are highlighted below:

1. Peaking Unemployment

Although most investors equate a booming real estate market with rising home prices, most REITs maintain minimal exposure to residential real estate. Although some own apartment complexes, the majority of REIT investments are in commercial, industrial, and retail real estate. So one of the metrics that often has a major impact on REIT prices is the unemployment rate. When job cuts mount, demand for office space slides and prices slump. When new jobs are being created, however, businesses are generally looking to expand. And expansion means adding and upgrading office space, which often leads to increases in rental rates and declines in vacancy.

The unemployment rate has technically now reversed course, although the number of out-of-work Americans continues to rise. Part of the run-up in real estate ETFs reflects optimism that upcoming data reports will show job creation and that the unemployment rate will gradually retreat throughout the remainder of 2010. This theory will get its first major test later this week, when a highly-anticipated government jobs report is expected to show that the unemployment rate is holding steady around 9.7%.

2. Credit Thaw?

The recent residential mortgage meltdown had a devastating impact on the U.S. economy, sending home prices plummeting, freezing credit markets, and eroding consumer confidence. Some analysts have worried that a collapse in the commercial real estate sector would soon follow, and would be much worse than the turmoil caused by the residential mortgage market. In the next five years, some $1.4 trillion in commercial real estate loans will reach maturity and require new financing. Since commercial property values have fallen as much as 40% over the last two years, many of these properties are worth less than their owners owe, setting the stage for a financial disaster as the commercial real estate “doomsday” approaches.

But there are signs that commercial real estate credit markets are beginning to thaw. According to a recent survey of 56 banks released by the the Federal Reserve, eight respondents reported tightening standards for commercial real estate lending, while only one indicated it had relaxed lending standards. Although that data indicates that conditions remain tough, it was the lowest proportion of banks tightening standards on commercial real estate loans since 2006.

3. Impressive Earnings

While encouraging data releases are nice, investors ultimately want to see that improved fundamentals are translating into bottom line results. So far, components of several real estate ETFs have delivered impressive results. Simon Property Group, VNQ’s largest holding, failed to impress with its first quarter results, but did announce that average rent per square foot increased by about 3% over the previous year, suggesting that fundamentals driving real estate revenues are beginning to rebound.

Several other REITs have turned in solid earnings for the first quarter of 2010, further boosting hopes that a crisis can be averted; Equity Residential reported last week that occupancy was on the rise, while Vornado Realty Trust reported on Tuesday that first quarter earnings rose 59% over the previous year.

Outlook Remains Cloudy

Despite all the good news in the real estate sector, significant hurdles remain before VNQ and other REIT ETFs can reclaim pre-recession levels. Any uptick in jobs creation will likely have a lagged impact on vacancy rates, and pricing power for property owners should remain weak for the foreseeable future. And the mountain of commercial real estate debt coming due in coming years is a major issue that won’t be easily resolved. So be cautious before setting off in pursuit of the red-hot real estate sector–there’s still plenty of potential to get burned.

Disclosure: No positions at time of writing.