Talking Real Estate ETFs With IndexIQ’s Adam Patti

by on October 21, 2011 | ETFs Mentioned:

Adam Patti is the Chief Executive Officer and Founder of IndexIQ, a New York-based ETF issuer behind several of the most innovative ETF products to hit the market in recent years including several hedge fund replication ETFs. A few weeks ago, we spoke with Adam Patti to get his thoughts on the current real estate market, investor sentiment in the space, as well as the pros and cons of looking at small caps in the sector.

ETF Database (ETFdb): Thanks to the crash in 2008, many investors have shied away from real estate, is this still warranted? In other words, how does a real estate investment fit into a portfolio given current conditions?

Adam Patti (AP): I think real estate generally is a core holding, well not core in terms of equity and fixed income clearly, but it’s something that I think every investor should have exposure to for the long term. And In fact, real estate had performed well this past year prior to the last couple of months, even though the actual real estate market in the United States has been very soft.  The recent draw down in REIT prices provides an excellent entry point for long term investors with a robust dividend rate as an added bonus.

ETFdb: Some people argue that having your home is enough exposure to the real estate market but I’m guessing you don’t quite agree with that sentiment…

AP: Well I definitely don’t because any REIT product, regardless if it’s ours, is going to give you exposure to other sectors that are very different than the price action on an individual home whether it’s industrial or hotel or retail space. I think you need it all [Three Real Estate ETFs To Watch If The IMF Is Right].

ETFdb: Something that is really concerning to a lot investors is the low interest rate environment and obviously thanks to some comments by Bernanke, it’s going to stay around for at least another two years. How has this environment been impacting REITs in the U.S.? Is this a positive or negative factor for this sector?

AP: Well I think it’s a strong positive because REITs have very strong yields. So in a low interest rate environment, if you’re looking for dividend income, real estate is a natural place to be looking for that. And then it’s just a question of what type of exposure you want to get that yield.

ETFdb: Can REITs withstand an economic slowdown? Are they better positioned than other high yielding sectors such as utilities to weather a future storm?

AP: Personally I don’t know if it’s better than utilities necessarily, I think people want to have exposure to a lot of different asset classes to ensure that you’re well diversified for whatever the market might throw at you. Real estate has very unique characteristics that investors really need to have that exposure, particularly given this latest pull back because real estate has had a nice run over the last 12 months. With this recent pullback, yields are looking even more attractive and I don’t know if the real estate or the REIT market generally has much further to fall.

ETFdb: Why do you think that the REIT market does not have much further to fall?

AP: I should couch that in relatively to the market. So obviously if the S&P continues to go down and we keep seeing all of these problems in Europe then I guess most asset classes, other than maybe short- term Treasury bonds, could have more downside.   But also with the S&P, I think that REITs have already had a nice haircut and I look at it as a buying opportunity, particularly given the fat yields you can get by entering now.

ETFdb: How does a fund like the IQ US Real Estate Small Cap ETF (ROOF) which focuses on smaller firms, offer a different experience from its large cap counterparts?

AP: This is a common problem in ETFs generally, all of the very successful ETFs in the equity space, whether its REITs or agribusiness, they are really focused on these mega-cap multinationals – they are all concentrated in the same names. So if you look at the top ten holdings – I did this on your website, which is my go-to site by the way,– of any of these REIT products they are really all the same. So if people want to get into REITs, what are they doing? They are piling all of their money into these huge multi-billion dollar REIT ETFs or they are buying those individual names like Simon Property Group. And what you’re finding there is that market sentiment is pushing prices around, both on the upside and the downside.  As an investor you really want to be trying to uncover the hidden gems in the marketplace. You don’t necessarily want to go where everyone else is going [also see REZ: Crushing The Real Estate ETF Competition].

So, what one big hole is in the market is in the small-cap segment of the REIT universe. So if you look at a lot of different sectors it’s really the same case, you really want those hidden gems and I think that’s really important. Just like active managers, they are all trying to uncover alpha, how many alpha opportunities are there? Well the managers are competing for those alpha opportunities by going after the same sector, the same stocks in those sectors. There is a lot of opportunity in the small-cap sector generally and in particular the REIT sector, where these large-cap REIT ETFs pretty much ignore the small-cap sector all together. These small caps are also less followed by analysts.   So what you find when you really compare small-cap REITs vs. large-cap you see a lot of differences. First, you actually see that small-cap REITs have a much lower price to book and price to earnings than do the large-caps. And a lot of that is because the fact that they are not as widely held; there is not a lot of analyst coverage on these small-cap companies. You also find that the dividend yield on these small-caps is far higher than on the large-caps. Our dividend yield right now vs. VNQ is nearly double.

ETFdb: Why do you think there is this value tilt? Is it market sentiment or market forces in play or is there something more to it than that?

AP: I think that’s part of it. With Simon Property, when everyone is piling money into there, they are driving the price up and the dividend yield comes down. Another part of it is I think these smaller cap REITs need to incentivize investors to buy them thus a higher dividend yield adds incentive.

ETFdb: Would you consider a product like ROOF kind of a complement to these large-cap oriented funds or do you think it’s a standalone fund for exposure to real estate?

AP: Honestly, I think it’s a standalone, or it could be, but from a portfolio perspective and taking off my IndexIQ-hat, we really position all of these products, all of our small-caps, as compliments to the large-caps. Our small-caps provide a little more diversification and they complete investors’ portfolios in those asset classes. ROOF is the bottom ten percent of the market capitalization in U.S. REITs. So even if you just take 10% of your VNQ allocation and put it into ROOF, at least you can extend your portfolio. I would always push for a little higher, considering you get a higher beta play and a higher dividend yield, you would probably want to go above the 10% range [see Talking Hedge Fund ETFs, Inflation-Proofing, And More With Adam Patti].

ETFdb: How does ROOF compare in terms of its sector breakdown? I noticed on your latest fund fact sheet, you have a lot of exposure to mortgage REITs, office REITs, and retail. How does this compare to other funds in the space?

AP: When I look at VNQ, they actually have zero exposure to mortgage REITs according to their sector breakdown. However, they have 26% in the specialized category, which may include mortgage REITs. Specialized also includes student housing, self-storage, things like that—all the niche segments.   ROOF actually provides a very well diversified sector experience when compared to the large cap REIT ETFs [see all the Real Estate ETFs here].

ETFdb: Do you feel that ROOF has a more diversified grouping of exposure to the sectors?

AP: I think so, we do have 24% in mortgage REITs but if you look at their retail allocation theirs is 25%-26% retail. There’re at 16% to office; we’re at 16.05%. We have 14% in hotel, they have zero – unless again, they include that in specialized. So I think we have a well-diversified portfolio with a little bit of a skew to mortgage REITs. Mortgage REITs did get hammered over the past 30 days. But, they also pay the highest dividend. They will come roaring back when the market stabilizes. Furthermore, the dividend on ROOF is close to 7.7% while many large competing funds in the space have yields less than half of that with some approaching just 3.9% [see more on ROOF's Fact Sheet].

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Disclosure: No positions at time of writing.