Joe Rodriguez, Head of Global Real Estate Securities for Invesco Real Estate and lead portfolio manager for the PowerShares Active U.S. Real Estate Fund (NYSE Arca: PSR), gives us his perspective on real estate investing. Rodriguez is a member of the National Association of Business Economists, the American Real Estate Society and the Business Advising Board for the Hankamer School of Business at Baylor University.
Brad Zigler (BZ): You actively manage a real estate ETF. Is that unique among domestic funds?
Joe Rodriguez (JR): Yes, the PowerShares Active ETF is the first actively managed U.S. real estate focused ETF.
BZ:What's the investment philosophy? From what universe are component REITs selected? Any screens employed?
JR: Invesco Real Estate’s philosophy is based on two guiding principles: to maximize predictability and consistency of returns and to minimize risk. Our goal is to build a well-diversified portfolio with a focus on better quality companies with higher expected risk-adjusted returns.
The investable universe includes all equity REITs defined by the FTSE NAREIT Index. We specifically exclude mortgage REITS from consideration as we consider them leveraged fixed income instruments rather than commercial real estate.
BZ: Why would an investor want an active ETF versus an index portfolio?
JR: In an inefficient asset class, such as real estate, managers have a greater potential to generate alpha relative to more efficient asset classes such as large-cap equity. There are gaps in knowledge and pieces of information that have not been fully priced into the market. Invesco believes active management may provide greater relative value compared to an index portfolio.
BZ: How does PSR's yield compare with that other real estate ETFs? What's likely to be the yield trend?
JR: The average dividend yield on the companies in the PSR portfolio tends to be below that of the REIT index average as our investment process targets companies with better earnings and asset value growth potential. These companies generally carry lower yields than the index because they use retained capital to fund future growth opportunities. Over the long run, Invesco believes the companies with higher growth may produce better total returns, including a higher dividend growth rate.
BZ: What about volatility? In the past year, PSR's been more volatile than the S&P 500 and the rest of the domestic REIT field. That's been good as the market uptrended. REITs, as well as other equities, have now retraced some of their recent gains. What's the prospect for PSR in a downtrend? Is its higher volatility a greater risk for investors?
JR: From a cash flow perspective, real estate is a less volatile sector given the contractual nature of the leases which underpin the cash flows. However, volatility can increase, especially during periods when REIT share prices are driven by macro factors and not based solely on property fundamentals. For example, volatility increased during and in the immediate aftermath of the global financial crisis. In more recent periods, though, volatility decreased when fundamentals and market structure stabilized. There may continue to be periods of volatility but we will actively manage the portfolio’s risk profile to achieve a favorable trade-off between risk and return.
BZ: Are REIT ETFs a replacement for some part of an equity allocation in investors' portfolios? In your opinion, what's a reasonable carve-out for a fund like PSR?
JR: REITs, which tend to have semiannual or quarterly dividends, may be beneficial for investors’ annual spending requirements. While not a prediction of the future, real estate securities have experienced long-term favorable returns that have surpassed broad equity markets over the last two decades. REITs have also been shown to perform well in periods of rising inflation. Lastly, REITs provide diversification opportunities. Over the long-term, REITs have shown moderate correlation to U.S. stocks and very low correlation to both U.S. and global fixed income indices. In general, an allocation to REITs has been found to improve the overall risk and return profile of an investor’s portfolio.
Adam Patti, Chief Executive Officer of IndexIQ, the issuer of the IQ U.S. Real Estate Small Cap ETF (NYSE Arca: ROOF), takes a different approach to domestic real estate. Prior to founding IndexIQ, Patti led Fortune Indexes, a pioneer in the exchange-traded fund industry and also served as Associate Publisher of the Time Inc. Business & Finance Network.
Brad Zigler (BZ): You manage an indexed portfolio of small capitalization REITs. Is ROOF unique in the universe of domestic REIT ETFs? What sets ROOF apart from other REITs?
Adam Patti (AP): ROOF is the only ETF to access the small cap segment of the U.S. real estate marketplace. We focused on the small cap segment for a variety of reasons. First, large cap REITS no longer provide the diversification benefits they once did. There are billions of dollars flowing into the large cap REIT ETFs and those products are typically concentrated in the same big name firms. The correlation of those products to the broad equity market is far higher than in the old days when financial advisors bought REITs for portfolio diversification. Second, due the overbought nature of large cap REITs, we’ve found that the portfolio of small cap REITs in ROOF trades at 20 to 30 percent valuation discounts to the large cap universe. These discounts appear in the price-to-earnings, price-to-cash flow and price-to-book ratios. Third, ROOF offers a dividend yield that is nearly double that of the large cap REIT ETFs. Fourth and last, small cap REITs typically outperform large caps. ROOF doubled the price performance of the large cap REIT ETFs over the past 12 to18 months.
BZ: What's the most compelling reason an investor would favor ROOF over another REIT ETF? Any drawbacks to investing at the small end of the cap spectrum?
AP: ROOF presents investors a way to efficiently buy the most dynamic and previously inaccessible segment of the REIT marketplace, a segment that offers investors the opportunity for better price performance, twice the dividend yield as large caps. It’s simply a far less crowded space then the large cap REIT segment.
BZ: Talk about the yield differential between ROOF and the rest of the domestic REIT world. What is it? What's likely to be the trend?
AP: ROOF's yield, which is currently around 5.5 percent, is approximately double that provided by the large cap REIT ETFs in the market. This gap has been consistent over the past several years during which we had researched and launched ROOF. Much of it is due to the fact that large cap REITs are consistently overbought. Billions of dollars flows into the "brand name" individual companies and the large cap REIT ETFs which typically hold somewhere between 25 to 40 percent of their portfolios in their top ten holdings. When REITs are in favor, the market pours capital into the same names, pushing up their prices and reducing their dividend yields. This isn’t occurring in the small cap portion of the market. Until ROOF was launched, the small cap segment wasn’t easily accessible to investors unless they happen to be REIT analysts who follow that portion of the market. ROOF holds the "hidden gems" in the market, companies that are overlooked by the vast majority of investors.
BZ: What about volatility? Your fund’s more volatile than equities and the rest of the domestic REIT field. Now that the market’s retreated, what's the prospect for ROOF? Is its higher volatility a greater risk for investors?
AP: While ROOF has slightly higher volatility then large cap REIT ETFs, this would be expected given that ROOF holds smaller companies. However, the interesting point is that the difference between large and small cap securities is typically far more pronounced. ROOF held up quite well during the latest downturn, providing a similar drawdown during some of the big market dips as the large cap REIT ETFs. The reason the volatility profiles are more similar then you might expect is that when REITs suddenly become out of favor, investors as a group sell the large cap REIT ETFs and the well known REITS that comprise the majority of those portfolios. There are so many billions of dollars chasing those large cap securities that the in and outflows impact the share prices. Everyone heads to the exits at once and everyone buys back at the same time. They’re selling and buying the same securities. This drives volatility higher for those large cap securities, far beyond that which would be expected. Recent market volatility has taken a toll on equity prices generally and ROOF, in particular, provides an excellent entry point for yield oriented investors. Now that the share price of ROOF has dropped, investors can buy into a higher dividend rate then they could have a month ago.
BZ: Are REIT ETFs a replacement for a chunk of an investor’s equity allocation? In your opinion, what's a reasonable carve-out for a fund like ROOF?
AP: Given how entrenched the large cap REIT ETFs are in investor portfolios, we position ROOF as a complement to the large cap ETFs. We advise clients to carve off 25 to 50 percent of their existing REIT allocation to invest in ROOF to extend exposure into the more interesting small cap segment and diversify their current overconcentration in the mega cap REITs. A client’s overall allocation to REITs depends on their individual investment goals. REITs, as well as other asset classes should be part of a well-diversified portfolio. Typically, we see investors holding REITS for five to ten percent of their overall portfolio. Many investors, however, have increased their allocations to REITs over the past 12 to 18 months to take advantage of robust yields and the improving real estate market, the latter of which, in our opinion, still has a ways to run.