The Definitive Guide To Real Estate ETFs: Real Estate ETF Investing 101

by on November 25, 2009 | Updated December 7, 2009

Once considered a vital “return enhancer” in almost every portfolio, real estate as an asset class has fallen out of favor with investors following its spectacular collapse during (and role in causing) the recent global economic downturn. Real estate was historically embraced because of its potential for delivering excess returns in bull property markets and low correlation with traditional stock and bond investments. But as default rates skyrocketed, values plummeted, and correlations went to 1.0, asset managers have sold off real property and reallocated investor portfolios to equities and fixed income.

Taipei 101, One of The World's Most Valuable Pieces Of Real EstateDespite its fall from grace, real estate is beginning to creep back into portfolios, as investors regain their appetite for risky assets (we include a small allocation to real estate in several of our All-ETF Model Portfolios). Real estate ETFs have seen cash inflows of more than $3 billion year-to-date, reflecting perhaps a preference for achieving diversified exposure within this asset class instead of concentrating assets in a few REITs. For investors looking to make a play on real estate through ETFs, there are several options offering different levels of risk, current income, and exposure to sectors of the market.

Overview Of Real Estate ETFs

Real estate ETFs generally invest in real estate investment trusts (“REITs”), a tax designation for companies investing in real estate that may provide desirable tax benefits. REITs must distribute at least 90% of their income to investors, and offer an efficient way for investors to gain indirect exposure to real estate prices (as opposed to direct exposure gained through ownership of a residential property).

Residential property ownership immediately comes to mind when most investors think of real estate investing. However, residential real estate makes up only a small component of most REITs, with the majority of holdings composed of commercial and industrial properties. As such, while releases of statistical bulletins tracking home resales and median prices are of great interest to most homeowners, they ultimately have little impact on prices of commercial real estate (and therefore real estate ETF prices).

Types of real estate generally owned by ETFs include:

  • Apartments
  • Health Care Facilities (e.g., hospitals)
  • Shopping and Strip Malls
  • Office Space (including mixed industrial/office)
  • Storage Facilities
  • Hotels
  • Manufactured Homes
  • Factory Outlets

Commercial real estate values depend on a number of factors, including prevailing rent rates. During economic booms, many companies are looking to expand their operations, and office space can become a hot commodity. But during downturns, spikes in unemployment (which is now above 10% and still rising) can quickly erode demand. Other factors impacting real estate prices include availability of financing and construction activity, both of which can spur or hinder creation of new property.

Next Shoe To Drop?

While residential real estate has been battered by spikes in mortgage defaults and foreclosures, commercial real estate has come through the recession relatively unscathed. At least to this point. Many analysts believe this industry is on its last legs, and that a collapse is a matter of when, not if. “After two years of one financial crisis after another, the Fed has fewer cards to play, and the foreign investors who bailed out commercial real estate investors in the past are sitting on the sidelines waiting for the prices to collapse,” writes Stuart Saft. “This problem is exacerbated by the lingering effects of the recession: absence of credit; growing job losses as a result of falling prices, consumer demand and credit; the insolvency or near insolvency of so many institutions; and the loss of confidence in the U.S. economy by our trading partners.”

Saft goes on to note that over the next three years, $1.3 trillion of financing comes due, only a fraction of which can be refinanced. While the effect of chronic over-leveraging has taken longer to buckle the commercial real estate sector than it did residential properties, the impacts could be just as crippling.

Popular (And Not So Popular) Real Estate ETFs

The most popular real estate ETFs tend to be diversified funds splitting exposure between commercial, industrial, and residential properties. Several of these funds are profiled below (see a complete list of domestic real estate ETFs here)

  • iShares Dow Jones U.S. Real Estate Index Fund (IYR): The largest domestic real estate ETF by both assets and daily volume, IYR invests primarily in industrial and office REITs (25.8%), specialty REITs (21.8%), and retail REITs (20.1%). IYR charges an expense ratio of 0.48%, on the high end for real estate funds.
  • SPDR DJ Wilshire REIT ETF (RWR): This ETF has about 80 individual holdings and an expense ratio of 0.25%. RWR’s largest weightings are to apartments (15.1%), healthcare (14.3%), and regional malls (14.1%).
  • Vanguard REIT ETF (VNQ): Vanguard’s real estate ETF offers both depth of holdings (97 components) and cost efficiency (expense ratio of just 15 basis points). VNQ has large allocations to specialized REITs (28.2%) and retail REITs (25%).

In addition to these broad-based ETFs, iShares offers three more targeted real estate funds, including:

  • FTSE NAREIT Residential Index Fund (REZ)
  • FTSE NAREIT Industrial/Office Index Fund (FIO)
  • FTSE NAREIT Retail Index Fund (RTL)

As their names suggest, these ETFs focus on targeted sectors of the U.S. real estate market. REZ, for example, has big holdings in REITs such as Equity Residential, while RTL is tilted towards mall owners like Simon Property Group and Kimco Realty Corp.

Global Real Estate ETFs

For investors looking to increase their exposure to real estate but wary of the growing cracks in the U.S. commercial real estate market, there are a number of global real estate ETFs, including country-specific funds and diversified global funds (see a complete list of global real estate ETFs):

  • SPDR DJ Wilshire International Real Estate ETF (RWX): This ETF offers exposure to real estate in more than 15 different countries, including both developed and emerging markets.
  • WisdomTree International Real Estate Fund (DRW): While DRW offers exposure to many of the same countries covered by RWX, it utilizes a very different weighting methodology. DRW is a fundamentals-weighted product, basing allocations to each component on cash dividends paid.
  • Claymore/AlphaShares China Real Estate ETF (TAO): The only ETF to invest exclusively in Chinese REITs, TAO has delivered impressive returns to investors over the last two years. TAO invests in publicly-traded companies and REITs that derive the majority of their revenues from real estate development, management and/or ownership of property in China or the Special Administrative Regions of China, such as Hong Kong and Macau.

Best Of The Rest

In addition to traditional long exposure to domestic and international real estate markets, there are several ETFs offering unique opportunities for exposure, including:

  • PowerShares Active U.S. Real Estate Fund (PSR): The only actively-managed ETF focusing exclusively on real estate, PSR had outperformed the FTSE NAREIT Equity REITs Index by nearly 40% since its inception in November 2008 (note that numbers are through the third quarter of 2009).
  • iShares Barclays MBS Bond Fund (MBB): This ETF holds mortgage-backed securities issued by FHLMC, FNMA, and GNMA, offering indirect exposure to the real estate market through investments in mortgages.
  • Leveraged Real Estate ETFs: Both ProShares and Direxion offer options for investors looking to gain leveraged exposure to real estate. ProShares’ 200% (URE) and -200% (SRS) funds are linked to the Dow Jones U.S. Real Estate Index, while Direxion’s 3x bull (DRN) and 3x bear (DRV) are related to the MSCI U.S. REIT Index.
  • Major Metro Housing Up (UMM) and Down (DMM): These paired exchange-traded products from MacroShares are linked to the S&P/Case-Shiller Composite-10 Home Price Index, pledging assets to each other based on the level of this widely-accepted home price benchmark.

Disclosure: No positions at time of writing.