Are Small Cap REITS Undervalued?

by: , Chief Investment Officer and Managing Director | IndexIQ

While they’re straightforward on the surface, when you look beneath the hood, Real Estate Investment Trusts (REITs) can quickly become more complicated. At their core, they acquire properties and generate income from leases, passing on that income to shareholders. Large cap REITs generally own larger properties; small cap REITs smaller ones. ETFs like the IQ US Real Estate Small Cap ETF (ROOF) invest in multiple REITs based on the rules of an underlying index. In the case of ROOF, the average market cap of the REITs in the fund was just under $2 billion on May 31, 2019. That compares to an average market cap of over $26 billion for large caps.

Small cap REITs have tended to carry higher yields than their large cap counterparts. For ROOF, the 12- month yield was 6.54% as of May 31, 2019. IQ US Real Estate Small Cap ETF (ROOF)-Prospectus. This compared to a yield of 3.85% for the FTSE Nareit US Real Estate Index during that same period (Source: Bloomberg). REITs are required to pass along at least 90% of their income annually to shareholders.

REITs are generally valued on a metric called “funds from operations,” or FFO. FFO is calculated by adding depreciation and amortization to earnings and then subtracting the value of any sales. It’s effectively the cash flow generated by the REIT and represents money that can be paid to shareholders in the form of dividends. Dividing the REIT share price by FFO gives you a ratio that can be used to compare the valuations of REITs across property types (apartments and office buildings, for example) and market caps, much like a price-to-earnings ratio.

A look at the current FFO ratios for large and small cap REITs shows that small caps are trading at a substantial discount to large caps: 12.6x compared to 17.3x as of March 31, 2019. The last time the ratio was lower was in March of 2016. Over the next 12 months, small cap REITs (ROOF) outperformed large cap REITS (VNQ) by over 1000 bps.  (Source: Bloomberg)

There are a number of possible reasons why this discount has widened. For some investors, REITs may have proven an attractive way to potentially sidestep the negative impact of trade wars, assuming the properties are domestic and the cash flows are generated in the U.S. These individuals may have gravitated to the large cap sector, pushing prices and valuations up. There may be concerns that smaller properties are more vulnerable to an economic slowdown, again causing investors to move towards large cap.

While there’s no one obvious reason, the data is clear: based on historic valuations, small cap REITs are trading at an unusual discount and, at the same time, are offering substantially higher dividends than large caps. How long this dislocation will persist is anyone’s guess, but it suggests that small cap REITs are currently worth a close look. Yields are attractive and, should the valuation gap be closed through small cap appreciation, there could be an opportunity for capital gains as well (Source: Bloomberg, as of March 31, 2019).

Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value.

This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.

The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.

This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.

Click on the fund name for the most current fund page, which includes, the prospectus, investment objectives, performance, risk, and other important information. Returns represent past performance which is no guarantee of future results. Current performance may be lower or higher. Investment return andprincipal value will fluctuate, and shares, when redeemed, may be worth more or less than their original cost. Visit nylinvestments.com/etfs and nylinvestments.com/funds and for the most recent month-end performance.

Before considering an investment in the Fund, you should understand that you could lose money.

Investments in REITs are subject to the risks associated with the real estate market and mortgage investing. These risks include fluctuating property values, changes in interest rates, property taxes and mortgage-related risks.

Dividends fluctuate and are subject to change.  There is no guarantee they will continue to be paid. While dividends may cushion returns in down markets, investments are still subject to loss of principal amount invested.

As the Fund’s investments are concentrated in the real estate sector, it is exposed to concentration risk, interest rate risk, leverage risk, property risk and management risk. The Fund is concentrated in small capitalization companies, whose stock prices generally are more volatile than those of larger companies. The Fund is non-diversified and is susceptible to greater losses if a single portfolio investment declines than would a diversified fund. The Fund is not suitable for all investors. Investors in the Fund should be willing to accept a high degree of volatility in the price of the Fund’s Shares and the possibility of significant losses. An investment in the Fund involves a substantial degree of risk and the Fund does not represent a complete investment program. The IQ US Real Estate Small Cap Index is the exclusive property of IndexIQ which has contracted with Solactive to maintain and calculate the Index. IndexIQ® and IQ® are registered service marks of IndexIQ.

The REIT-focused FTSE Nareit U.S. Real Estate Index Series tracks the performance of the U.S. REIT industry at both an industry-wide level and on a sector-by-sector basis.

“New York Life Investments” is both a service mark, and the common trade name, of the investment advisors affiliated with New York Life Insurance Company. IndexIQ® is an indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC and serves as the advisor to the IndexIQ ETFs. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.

1820016

Salvatore J. Bruno

Chief Investment Officer and Managing Director | IndexIQ

Sal is Chief Investment Officer at IndexIQ, where his primary responsibility includes developing and maintaining the firm’s investment strategies. Sal joined IndexIQ in 2007 from Deutsche Asset Management (DeAM) where he held a number of senior positions

Full Bio

Leave a Reply

Your e-mail address will not be published.