Some Challenges Ahead For REIT ETFs

Real estate investment trusts and the corresponding exchange traded funds are benefiting as investors seek out more defensive sectors, but as the business cycle ages, some analysts see risks ahead for REITs.

The iShares U.S. Real Estate ETF IYR, one of the largest real estate ETFs, is sporting a modest year-to-date gain and is slightly outpacing the S&P 500.

What To Know

While IYR and rival REITs are proving surprisingly sturdy as the Federal Reserve continues raising interest rates, several other factors could pressure the group next year.

“Slower internal growth, pervasive net asset value (NAV) share discounts and headwinds for commercial real estate (CRE) values will test the generally more conservative REIT financial policies this cycle as REITs consider funding avenues for external, primarily development-led, growth strategies next year,” said Fitch Ratings.

IYR, which tracks the Dow Jones U.S. Real Estate Index, holds 114 real estate equities.

Why It's Important

“Modest, primarily rent spread driven, same-store net operating income (SSNOI) growth will yield minimal incremental leverage capacity under current financial policy commitments,” said Fitch. “Development oriented REITs are better positioned given incremental NOI from new deliveries. However, the temptation to reload development pipelines has, or will, eliminate much of the near-term benefit.”

IYR allocates over 27 percent of its combined weight to residential and retail REITs, corners of the REIT space that could be vulnerable to declining rents and further erosion in the brick-and-mortar retail trade. Other data points underscore investors' renewed affinity for real estate funds.

IYR's three-year standard deviation of 11.47 percent is well below the volatility metrics on growth sectors, the fund's price-to-earnings ratio is well below that of the S&P 500 and the REIT ETF yields 3.73 percent on a trailing 12-month basis, according to issuer data.

What's Next

CRE fundamentals remain solid and that is a plus for real estate funds.

“CRE fundamentals are generally balanced. Industrial is experiencing strong e-commerce related demand, retail varies by format with solid grocery-anchored strip centers and struggling class B malls, and healthcare is facing headwinds due to changing patient care settings and government reimbursement policies,” said Fitch. “Multifamily is working through excess supply in certain markets and office market performance is bifurcated by exposure to tech employment but both should have SSNOI growth.”

IYR devotes 5.63 percent of its weight to industrial REITs.

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