VNQ: Active approach prevails, but passive investors can benefit

Vanguard Real Estate Index Fund Shares ETF (NYSEARCA:VNQ) is an answer for investors who want exposure to the broad real estate market without spending time on detailed analysis of different market segments or representatives. It is understandable why investors are leaning towards such a solution as it saves time and can still provide attractive income and total return.

Investment Thesis

As an investor very focused on the REIT sector, I prefer to choose my investments. I have a long experience in the field and a background in finance, and I find it relatively easy to compare the values ​​of different REITs. Therefore, I prefer to stick with my approach and have never held a position in VNQ.

However, as I recognize that not everyone is willing to take the time to look into such things, I consider VNQ to be a valid the option to build a passive and reliable exposure to the real estate market. This ETF has:

• Maybe modest (by the standards of some real estate sectors), but still attractive dividend yield of 3.6%
• Diversification in various real estate sectors
• A reasonable expense ratio of 0.13%.
• Positive market dynamics accompanying the subsequent appreciation

While VNQ may be considered a “buy” for passive investors looking for exposure to the real estate market, which is likely to be supported by significant tailwinds in the coming years, I will put this on “hold” as I believe the REIT sector. offers relatively easy cherry picking processes. By the end of this article, I’ll provide some examples of why I think cherry-picking the REIT sector is a more attractive approach for me, and maybe for you.

Frankly, unless you’re completely disinterested in taking a more active approach to the real estate market, feel free to stick with VNQ and keep accumulating, as this ETF has a solid value proposition. However, if you’re willing to try cherry-picking, more power to you – let me urge you to put VNQ on “hold” and allocate elsewhere.

Let’s unpack VNQ

Four real estate sectors have a double-digit share in the composition of VNQ:

• Retail REITs with a share of 13.2%.
• Telecom Tower REIT with a share of 12.2%.
• Industrial REITs with a share of 12.1%.
• Health care REIT with a 10.5% cap.

The ETF also provides exposure to data center REITs, residential REITs, self-storage, etc.

As a result of the VNQ acquisition and its composition, investors gain exposure to 155 REITs, some of which are (naturally) dominant over others. VNQ’s top 10 holdings consist of (excluding the Vanguard Real Estate II Index Institutional Fund):

• Prologis (PLD)
• American Tower (AMT)
• Equinix (EQIX)
• Tower of Wells (WELL)
• Simon Property Group (SPG)
• Public Storage (PSA)
• Income from real estate (O)
• Digital Realty Trust (DLR)
• Crown Castle (CCI)
• Extra Storage (EXR)

The aforementioned holdings represent a 37.9% share of VNQ, excluding the impact of the Vanguard Real Estate II Index Fund Institutional, which further increases their share.

There is no denying that each entity mentioned above is a top choice in its respective field; however, I don’t like the prominent exposure to data center REITs, or the fact that one of the best sectors to invest in today in the broad REIT sector — the industrial property segment — remains so heavily represented by a single holding (6.7% without factoring). in the institutional ETF of 12.1% represented by a single holding).

Tailwinds support VNQ

Different factors and market dynamics accompany various real estate sectors. For example, the industrial property sector faces oversupply issues from mid-2022, net lease REITs that rely heavily on acquisitions are struggling with lower transaction activity in the market, and AI-driven tailwinds accompany data center REITs.

However, one specific factor strongly affects the broad REIT sector regardless of the specific property segment: the interest rate environment.

The rising interest rate environment since early 2022 has been a major headwind for the REIT sector for several reasons:

1. First of all, increased the cost of debt through higher variable rate debt costs and higher refinancing costs. When REITs wanted to refinance their previous debt (pay off debt using new debt), they typically paid down lower cost debt with higher cost debt due to the higher interest rate environment.
2. Secondlythe transactional activity of the market decreased. In the high interest rate environment, the valuation gap between buyers’ and sellers’ expectations is relatively large, leading to weaker supply capacities and lower potential to secure attractive investments. This is a crucial factor for REITs as their growth is mainly driven by their investment activities.
3. thirdly, with many investors leaving REITs for “safer” instruments (eg bonds) and reduced growth potential through limited investment activity, the valuations of most REITs have fallen considerably. As a result, their cost of equity increased, adding to the problems listed above.

As a result, VNQ has seen a 36.8% decline in price from 2022 to 2023. However, this has changed with VNQ’s YTD performance and I believe this reversal trend will continue over the next two years.

In 2024, VNQ has seen price growth of 11.6%, but still has a long way to go before matching its pre-rate hike levels. What facilitates and will continue to facilitate this change?

According to CME Group’s FedWatch tool, the Fed is likely to loosen monetary policy and the market expects interest rates to fall significantly by the end of 2024 and over the next 12 months.

The potential recovery will facilitate the transactional market, which has already seen some positive changes. For example, the retail real estate sector – Agree Realty (ADC) and Essential Properties Realty Trust (EPRT) delivered higher investment volumes in Q2 2024 than in Q1 2024. Furthermore, ADC upgraded its guidance on investment volume for 2024. These developments suggest that the gap between buyers and sellers has already narrowed. REITs are returning to the good graces of investors by improving their equity and total cost of capital, leading to greater abilities to secure positive investment spreads.

Monetary easing will further facilitate the development of top REITs and thus VNQs.

Assessment perspectives and risk factors

Each stock market investment is accompanied by market and instrument specific risk factors, which in the case of VNQ may include:

• uncertainty regarding the interest rate environment
• limited ability to adjust portfolio to specific market trends accompanying different real estate sectors if solely based on VNQ
• the index relies heavily on a relatively small pool of entities, leaving out smaller market players that often offer better risk-reward ratios and stronger performance (eg EPR Properties ( EPR ), Rexford Industrial ( REXR ), First Industrial Realty (FR), Agree Realty, etc.)
• Income-oriented investors can build a higher-yielding portfolio with a similar margin of safety through investments that raise

However, I expect the price of VNQ to rise in the coming quarters/years due to the major shift in the interest rate environment that underpins each of the fund’s holdings. While the growth potential has already been visibly realized, there is still some meat on the bones to reach double-digit total returns. Especially given that REITs tend to outperform after FED tightening cycles:

Extra Supply: Consider cherry picking

Due to increased volatility and some macroeconomic difficulties, the past two years have presented many opportunities in the REIT market. Even though I started my journey on Seeking Alpha in May 2024, I have already been able to present many performing opportunities.

Most of them are severely underrepresented in VNQ, so I will focus on them. Of course, take this with a grain of salt, and if that’s not your thing, feel free to stick with VNQ or other ETFs that facilitate your passive approach to financial freedom. No path leads to a common goal.

However, let me introduce you to three of the many options I’ve shared on Seeking Alpha. I’ve got my own advice for each so you can be sure I have my skin in the game.

Case #1 – Agree Realty

My first ADC article has aged quite well:

Agree Realty Corporation: Elite-level business values ​​with room to outperform

Since then, the company has delivered an outstanding total return of over 30%, significantly outperforming most REITs, even those operating in the same real estate sector. It even outperformed Realty Income, which is very well represented in VNQ. ADC also pays monthly dividends and operates as a triple net lease REIT focused on retail/service properties, but has higher portfolio quality and stronger business and credit values.

Agree Realty is only ~0.4% of VNQ exposure.

Case #2 – EPR properties

This is one of my all-time favorites in the REIT sector. The market has clearly overestimated the risk factors accompanying EPR, leaving their valuation multiple detached from their long-term ability to generate cash flows and a clear turnaround strategy. EPR was my debut article on Seeking Alpha:

EPR Properties: One of the best risk-reward ratios in the industry

Since then, the company has delivered an attractive total return of 14.6% and has also enabled investors to secure a high dividend yield of 7-8%.

EPR represents only ~0.2% of VNQ exposure.

Case #3 – VICI Properties (VICI)

VICI Properties operates in a specific gaming niche accompanied by unique value drivers. Its tenants have limited ability to change location or negotiate better terms, which ensures stability and predictability of VICI’s cash flow. It also supports them outstanding business values showing 100% occupancy and one of the highest (or highest) WALTs in the REIT sector.

VICI is one of my largest REIT holdings. Since my coverage, the company has delivered a total return of 19.8%, far trailing below-average REITs.

VICI Properties: Undervalued despite elite business values; I buy.