Preferred Asset for REITs: VNQ

Although I have long invested in REITs, I’m actually undecided about whether they are a unique asset class and if they deserve an allocation in a RP portfolio going forward. That being said, Vanguard’s Real Estate ETF (VNQ) is my preferred way to invest in REITs…for now.

"VNQ invests in stocks issued by real estate investment trusts (REITs), companies that purchase office buildings, hotels, and other real property. Its goal is to track the return of the MSCI US Investable Market Real Estate 25/50 Index."

Fund Home Page:

Vanguard Mutual Fund Profile | Vanguard

Barchart Page:

VNQ - Real Estate Vanguard ETF Price -
Real Estate Vanguard ETF etfs funds price quote with latest real-time prices, charts, financials, latest news, technical analysis and opinions.

The Basics:

This is somewhat of an awkward asset write-up - I’m not entirely sure whether REITs (real estate investment trusts) are a worthwhile asset class for RP investors, or even whether they are really an asset class at all. I currently do have REITs in the test portfolios (the RPC Income portfolio contains VNQ, and the RPC Growth contains DRN, a 3X leveraged version of that), so I wanted to make sure I did the write-up, but I’m planning on circling back to this in future posts.

To back up a moment, REITs are a different type of corporate equity structure that allow the trusts to skip the payment of corporate taxes as long as they pay out at least 90% of earnings to shareholders. You can thus use REITs to invest in real estate as you would other forms of equities, via a mutual fund or ETF format. REITs are used for a wide variety of real estate businesses, including holders of mortgages, commercial and industrial real estate, cell towers, and storage companies, among others. Since they pay out such a high proportion of their income to shareholders, they can resemble corporate bonds in their dividend rates and are a favorite of investors interested in regular income. Since they relate to the real estate industry, they should theoretically be subject to slightly different risks than most equities or fixed income, and will ideally be mostly uncorrelated to other asset classes.

The issue with them, though, is they may not be all that distinct after all. I’ll dive into this more later, but there are questions about whether they are indeed unique. In this video, Ben Felix reviews the evidence and cites two papers which say that they are NOT a distinct asset class and you’d likely be better off by increasing allocation to small cap value stocks and corporate bonds instead. If REITs are genuinely distinct, we’d expect low correlations with equities, but VNQ’s 60-month beta is .83, white its correlation to VTI is .75. Those numbers suggest REITs are another flavor of ice cream, not a unique dessert.

Nevertheless, REITs are so far part of my test portfolios and part of my real life portfolio as well, and, assuming one does consider them a unique asset class, Vanguard’s Real Estate ETF is my preferred way to invest. As usual, I look for ETFs with broad holdings and low expense ratios, and VNQ holds 171 REITs across the full spectrum for an expense ratio of just .12%. There is also just my general brand-loyalty to Vanguard, and truth be told, you’d get similar low-cost breadth from Schwab’s SCHH (.07% expense ratio) and Fidelity’s FREL (.08%). If I were starting to invest, either one of those might be the choice.

As you can see, VNQ really doesn’t have the kind of correlation profile that would make it a “no brainer” as an uncorrelated asset class to include in a diversified risk parity portfolio. With correlations of .75 and .78 to the total US market and small cap value stocks, respectively, VNQ tends to mostly just follow those. With a lower annualized return, it isn’t clear whether VNQ will actually add much to your portfolio. If you own a total US stock market like VTI you are already getting exposure to REITs anyway, and if you overweight towards small-caps you’re getting even more (since REITs generally are small-caps; just five of the 198 on my list had market caps above $50B). So really, the question of investing additionally in REITs means a conscious decision to overweight this type of equity even more, and that’s where it might not be worth it.

Other Options:

  • VNQ is by far the largest ETF in the indexed REIT space by assets under management and has approximately eight times the assets of its nearest competitors. Those include the two mentioned above: Schwab’s SCHH and Fidelity’s FREL, as well as State Street’s XLRE.
  • Another great alternative, in mutual fund form, is DFA’s Real Estate Securities Portfolio (DFREX) which I invest in through my 401k. It still has a low expense ratio (.18%) and has outperformed VGSIX, the mutual fund version of VNQ, over the past 24 years by one-half of one percent. It doesn’t offer much difference in terms of correlation profile, though, as its numbers are near-identical to those of VNQ.
  • A real alternative to investing in VNQ or REITs more generally in order to gain exposure to real estate might be simply to find other, more direct ways. I intend to explore these in depth in the future, but some possibilities I am looking at are Fundrise, Acretrader, and the worlds of syndication deals and “hard-money” private lending.
  • GroundFloor is another alternative and one that I am investing in currently (btw, this is an affiliate link; please see disclaimer #2 below). I definitely foresee a longer write-up in the future, but basically, this site connects real estate developers and private money lenders. Investors can expect between 6 to 12%, or rather,  those have been the returns recently though that is no promise of returns going forward, and typical holding periods of 3 to 12 months. I have been investing through the site for about four months now, and while it hasn’t been quite what I expected (mainly, repayment periods have dragged on a bit beyond what was announced), it has performed fairly well. Currently, my investment is rather small - I’m giving it about a year’s trial before I fully make up my mind.

Disclaimer #1: In real life, I own shares in VNQ and DFREX. Keep in mind that this site is intended for financial education, and this write-up is to explain how you might want to think about this particular fund in the context of Risk Parity. It's not necessarily a recommendation that YOU invest in it.
Disclaimer #2: I included the affiliate link for GroundFloor above, and if you sign up using that link, I do get a small payment from GroundFloor. This is the only affiliate link on my site, and I have been hemming and hawing about whether to include it. On the one hand, this is not a revenue-focused site; on the other hand, I do have costs related to running a blog and the payments will help defray them. So, if you’d like to sign up, great, but if you feel weird about affiliate links, just Google it and do so directly. Also, I’m still on the fence about whether GroundFloor is something I’ll put my stamp of approval on. I’m just dipping my toes in the water with it so far, so this is not necessarily a recommendation.