Location Matters: Why an Active Approach is Key in Real Estate Investing and REITs

For many investors – both income and capital gains seekers – real estate investment trusts (REITs) have become a cornerstone of their portfolios. It’s easy to see why. Offering exposure to a variety of commercial real estate property types, REITs offer a host of benefits, including their high yields, tax advantages and strong long-term total returns. With that, most investors get their exposure through passive and indexed vehicles

However, they may be selling themselves short.

As the saying goes, real estate is all about “location, location, location.” Different property types and areas feature different characteristics. And here, an active approach may be better. Luckily, new active ETFs have made getting proper REIT exposure easy.

IndexIQ’s New Fund

Insurer New York Life’s ETF subsidiary IndexIQ recently launched the IQ CBRE Real Assets ETF (IQRA). The fund is designed to provide a strong total return through capital appreciation and current income. To do that, IQRA will invest in a portfolio of global real estate and infrastructure common equity securities. The win for the fund is that it’s not passively managed or tracking an index. A team from global real estate and infrastructure powerhouse CBRE will make active selections for the fund: The bulk of assets are in real estate equities, with seven of the top ten holdings being REITs.

And New York Life and IndexIQ may ultimately have a hit on their hands when it comes to real estate investing and REITs.

Active Wins In REITs

When it comes to finding sectors that work well with an active touch, real estate is right near the top. The reasons are vast.

Real estate is a wide spectrum of assets. Not only do we have different property types and sub-types, but locational differences as well. This plays out with regards to winners and losers in the sector. For example, current trends suggest that some property types like apartments, self-storage locations and data centers have plenty of long-term tailwinds propelling them forward, whereas some sectors like offices and regional malls are facing plenty of headwinds.

Even here, it’s not so simple. In the current environment, it’s easy to paint a broad stroke and say all office owners are suffering. But as California-based Douglas Emmett (DEI) and NYC-focused S.L. Green (SLG) have dropped, Sunbelt-focused Cousins Properties (CUZ) has held its own.

For a passive REIT fund like the $79 billion Vanguard Real Estate ETF (VNQ) taking advantage of trends is nearly impossible. VNQ’s weightings for various real estate subtypes are within 2 to 3 percentage points of each other. But active managers can swoop in on locations and strong property subtypes to take advantage of shifts in the real estate market.

Secondly, real estate investing is all about cost of capital, cash flows, and debt levels. There are a lot of metrics and other points when it comes to real estate investing. Understanding how a firm has locked in mortgage costs, the effects of rising rates, property values, rent increases, etc. lend themselves to an active touch. Here managers can once again exploit values and strong firms to produce a portfolio of winners.

Finally, active managers looking to produce more yield can look beyond the largest REITs and into smaller names. Here, more often than not, small- and mid-cap REITs have high initial yields and strong rates of dividend growth.

All of this does make a huge difference. According to Morningstar, actively managed real estate funds have done well to beat their passive rivals. Over the last 1-, 3-, 5-, and 10-year periods, active funds have managed to outperform indexed funds by a wide margin. Over the last three years, 83.6% of active real estate funds beat their benchmarks. Over the last five years, the number is still the majority at 64.7%.

Active ETFs Can Help

The interesting point to Morningstar’s data is that over the long haul – 10 years – more than 50% of active real estate funds with the lowest costs have managed to beat their benchmarks. The highest cost funds have only a 31% beat rate. This helps prove that much of active funds’ stumbles have come from their high fee hurdles. And this is where active ETFs can significantly help.

Because of their lower cost to run, active ETFs make it easier for fund managers to outperform their benchmarks. The new IQRA has an expensive ratio of 0.65%, below the averages of both active mutual funds and active REIT mutual funds.

Better still, active ETFs can benefit from lower taxes. Thanks to their internal tax structure, REITs dividends are higher than the broader market. However, they don’t qualify for lower dividend tax rates. Because managers often change their holdings, capital gains can add a nasty tax surprise for investors holding REITs in a taxable account. But with ETFs, capital gains are eliminated and not passed on to investors.

As a category, REITs are just starting to get the active ETF treatment. However, the oldest fund in the sector Invesco Active U.S. Real Estate ETF (PSR) has been around since 2008 and was one of the first active ETFs overall.

Here's a summary of the top active ETFs for REITs to own.

The Bottom Line

For investors, real estate and REITs have been wonderful portfolio building blocks, offering high yields and other good long-term returns. These pointers are only made better by active management. Now, with plenty of new active ETFs on the block, investors have the opportunity to shine in the real estate sector.