Forget VNQ: Build Your Own High-Yielding Real Estate Portfolio

Introduction

According to Redfin, the median home price in the United States was $420 thousand in March, an increase of 4.8% compared to the prior-year period.

I’m bringing this up because, in Fort Worth, Texas, the tallest office building was just sold for just $12.3 million, a little less than 30x the median home price.

It’s a silly comparison, which I’m only using to show how cheap the building is.

Even worse, it was bought three years ago for $137.5 million.

That’s a 91% loss in just three years!

To quote the Daily Mail, it’s the result of a mix of various headwinds, including cyclical and structural:

Small and regional banks are the biggest source of credit for the commercial real estate market, holding about 80 percent of the sector’s outstanding debt.

‘I think this is an existential moment,’ said RXR real estate boss Scott Rechler.

‘This post-COVID world of higher interest rates, the changing nature of how people work and live, we’re not going back to where we were, and it’s going to be turbulent.’

A staggering 19.6 percent of US office spaces are unoccupied – the emptiest they’ve been in the last 40 years.

These issues are very serious, as the economy is hit by a toxic cocktail of elevated rates, sticky inflation, and a wall of maturities.

According to Newmark, the commercial real estate sector is faced with a wave of $2 trillion in maturities over the next three years! The sentence I just typed does not contain a typo.

Over the next twelve months (starting in April) alone, roughly $320 billion in CRE debt is about to mature.

As one can imagine, this is not great for the real estate sector, especially because we are dealing with a low probability that rates will come down soon.

Using Federal Reserve fund futures, we see the implied chance of a sub-4.75% interest rate on December 18, 2024, is below 20%. The current rate range is 5.25-5.50%.

As the chart above shows so well, since February, the market has consistently started to get used to the idea that “higher-for-longer” is a likely path forward for interest rates and inflation.

Obviously, none of this is great news for real estate stocks.

Over the past twelve months, the Vanguard Real Estate Index Fund ETF Shares (NYSEARCA:VNQ) has seen 2.2% in capital gains. During this period, the S&P 500 gained 27.1%.

Even worse, as we can see in the VNQ/S&P 500 ratio below, VNQ has been underperforming the S&P 500 on a very consistent basis since 2012. Note that the ratio below includes dividends!

In fact, investors who bought VNQ when it went public in September 2004 have underperformed the S&P 500.

Don’t get me wrong, this article is not going to be a hit job on the VNQ ETF – or real estate in general.

While I believe real estate may keep underperforming until we get a clear path to lower rates and inflation (the chart below compares the VNQ/S&P 500 ratio to the inverted U.S. 10-year yield), I want to present a few stocks I would use to build a real estate portfolio to generate income, growth, and potential outperformance compared to the benchmark.

On August 22, 2023, I did something similar in an article titled “VNQ ETF: I’m Building My Own Market-beating ETF,” where I experimented with a few diversified picks.

While these picks have returned 11.5% annually over the past ten years (see the data below), they have underperformed the VNQ ETF by roughly 250 basis points year-to-date, which is mainly due to investors taking profits in some high-flying stocks and headwinds in certain areas.

I’m not worried about this short-term underperformance, as I invest with a multi-year/decade time horizon.

Now, let’s dive into other investment ideas!

Not Bad At All, Just Not Good Enough

I like the VNQ ETF.

While I would not invest in it due to its poor performance (I also cannot legally buy it in the European Union), I believe it’s a fantastic benchmark to track the real estate sector.

Why?

That’s because the ETF is highly diversified, with a history that goes all the way back to September 23, 2004. This means we can use a lot of data to make comparisons and backtest strategies.

The ETF, which tracks the MSCI U.S. IM Real Estate 25/50 Index, has 158 positions with a median market cap of $26.7 billion. It also has $31 billion in net assets, making it one of the biggest ETFs across all sectors.

Furthermore, with regard to diversification, we see that the ETF offers good exposure to major real estate sectors, including industrials, retail, telecommunication, data centers, healthcare, real estate services, offices, and smaller sectors like timber.

While this diversification makes VNQ the go-to ETF for investors who want to buy the entire sector through one ETF, I believe we are dealing with a case of “diworsification.”

Diworsification is the process of adding investments to a portfolio in such a way that the risk-return tradeoff is worsened. Diworsification occurs from investing in too many assets with similar correlations that add unnecessary risk to a portfolio without the benefit of higher returns. – Investopedia

This also means that some of the best REITs on the market have a very low weighting in this ETF. The biggest individual holding is Prologis (PLD), with 7.6% exposure. I agree with that, as I’ll explain in this article.

However, the weighting quickly drops to less than 3% for the sixth-largest holding.

Again, this makes sense, as the ETF aims to offer diversified exposure.

The problem is that in an environment where REITs, in general, are being pressured by headwinds, I think it is important to have above-average exposure to the best in the businesses.

Once we get back to a favorable environment where the “tide lifts all boats,” VNQ becomes a much better pick for investors looking to avoid stock picking.

The Market-Beating Model Portfolio

As it’s a while ago since I wrote my most recent VNQ article, I decided to construct a new model portfolio, including:

• Self-storage assets. These give me consumer and housing exposure, as demand for storage is highly tied to consumer spending and people needing temporary space while moving.
• Industrial assets. In this case, I went with a special REIT, which focuses on advanced warehouses, as a sector that benefits from secular growth in e-commerce and economic re-shoring.
• Residential. Instead of picking single-family housing or apartments, I went with my favorite segment: manufactured housing.
• Net lease/retail. Net lease is a fascinating space with some of the greatest companies. In this case, I went with a net lease giant in the retail space.

Obviously, I’m leaving out a lot of real estate by focusing on four segments only. This also does not mean that I don’t like the sectors I did not include.

My point here is that I think I can build a mini portfolio containing some of the biggest real estate segments with long-term tailwinds without having to dive into highly specialized REITs to capture certain trends like artificial intelligence.

All REITs in this article are critical to the economy without being dependent on trends that can be disrupted easily. As I have a multi-decade time horizon, that’s very important to me.

Here are the picks:

Please note that I will refer to Seeking Alpha articles for further in-depth research on these picks, as I cannot give each company the attention it deserves in this article.

Extra Space Storage (EXR)

Earlier this month, I wrote an article on what has become the largest self-storage REIT in the United States. This has always been a favorite of mine, and I made it a core position in my dividend growth portfolio.

EXR has figured out the art of running a self-storage business, which is one of the most competitive REIT sectors on the market.

It has consistently beaten sector peers when it comes to revenue growth and core per-share FFO (funds from operations).

It currently owns more than 3,700 properties in 42 states. It has a BBB+ credit rating (just one step below the A range) and a 4.4% dividend yield, which comes with an 80% payout ratio and a 13.5% five-year CAGR.

Looking at the chart above, please note that EXR did not cut its dividend last year. It had to break up its dividend payment due to the acquisition of Life Storage. The total amount remained unchanged.

With regard to its valuation, EXR trades at a blended P/AFFO (adjusted funds from operations) ratio of 19.6x, a bit below its normalized 20.3x multiple.

While this year is expected to see flat AFFO, analysts expect low-to-mid-single-digit growth in the years ahead. These numbers are FactSet analyst expectations from the chart below.

The next one is an industrial REIT.

Prologis (PLD)

Prologis is on my buy list. I believe the stock would make a lot of sense in my portfolio, as I like to buy assets that are critical to major supply chains.

While Prologis operates in a highly competitive industry, it brings something special to the table: size and relationships.

As I wrote in a recent article, Prologis is a giant. It is the largest industrial REIT in the world. Focused on modern warehouses, it owns 1.2 billion square feet on four continents. It has roughly 6,700 customers who move $2.7 trillion in goods through its warehouses. That’s roughly 2.8% of global GDP!

Because it has advanced warehouses, it has great relationships with major players dependent on efficient supply chains. This includes transportation companies, e-commerce giants, car companies, and retailers.

While it’s still a cyclical company, these benefits provide secular growth tailwinds in e-commerce, supply chain modernization, economic re-shoring, and others.

It also needs to be said that despite current economic challenges, the company expects the vacancy rate in its largest market, the U.S., to decline again going into next year.

Thanks to a poor stock price performance since rates started to bite the industry, it now yields 3.6%, which comes with a 70% payout ratio and a five-year CAGR of 12.6%.

On top of that, it has an A-rated balance sheet and an AFFO multiple of 24.2x, which is slightly below its 25.7x multiple. After a potential 2% AFFO contraction this year, analysts expect 17% and 10% growth in 2025 and 2026, respectively.

The next REIT is also on my buy list.

Equity LifeStyle Properties (ELS)

The secular growth driver of ELS is housing shortages.

As I wrote in my most recent article, ELS is one of the largest owners of manufactured housing (“MH”) communities. It also owns RV communities and marinas.

Due to high rents and expensive mortgages, MH communities offer great alternatives – especially for retired people, which is a ground with strong growth in the company’s key markets.

On average, MH alternatives are up to 71% cheaper than single-family homes.

This has allowed ELS to consistently grow its earnings and outperform its residential peers.

Currently yielding 3.1%, the REIT has a 10.0% five-year dividend CAGR.

Trading slightly above its long-term normalized AFFO multiple (because investors have found a lot of value in ELS stock in recent years), I believe this REIT is a great buy if the market continues to weaken.

The next REIT has rapidly become a favorite among dividend investors.

Agree Realty (ADC)

Agree Realty may be the little brother of Realty Income (O). As discussed in a recent article, the company mainly leases to investment-grade tenants, including some of the nation’s largest defensive consumer companies, dollar stores, drug stores, and do-it-yourself giants.

Close to 90% of its tenants have investment-grade balance sheets, which is truly unique in this industry.

It is also the only company in this article with a monthly dividend, which has been hiked by 6% annually over the past decade.

Currently yielding 5.0%, the REIT also comes with an investment-grade balance sheet with a BBB rating.

Trading at a blended P/AFFO ratio of 15.0x, it trades at a slight discount to its longer-term normalized AFFO multiple of 15.4x.

If I were a more income-dependent investor, I would be a buyer of ADC.

Putting Everything Together

Combining these four assets in a model portfolio with an equal weighting, we get an annual return of 12.9% since January 2005. This beats the VNQ ETF by 670 basis points per year!

Even better, these four stocks have a better standard deviation (lower volatility) than the VNQ ETF (21.5% versus 22.3%), which has much better diversification!

As a result, it has a superior risk-adjusted return (Sharpe Ratio) of 0.61.

Even better, the model portfolio has consistently beaten the benchmark ETF.

• On a 10-year, 5-year, and 3-year basis, the model portfolio has beaten the VNQ ETF.
• Year-to-date, the model portfolio has underperformed, which I blame on the cyclical behavior of industrial and self-storage REITs.

With all of this being said, this is not a call to buy exactly these four REITs. I don’t think it would be a bad idea, but I’m just providing food for thought here.

What’s important is that we don’t need to buy ETFs to build diversified portfolios.

As long as we buy great assets with long-term tailwinds, strong balance sheets, and consistent dividend growth, we can build solid, low-maintenance portfolios.

I also wanted to show four of my all-time favorite REITs.

For now, I only own EXR from this list. However, both ELS and PLD are on my watchlist, as I would like to expand my REIT exposure, especially once we get to a point where the odds of prolonged subdued inflation become more favorable.

Takeaway

In a real estate market facing significant challenges, it’s crucial to navigate wisely.

While the VNQ ETF provides diversified exposure, it may not always capture the best-performing REITs.

By hand-picking assets with long-term growth potential, strong balance sheets, and consistent dividends, investors can construct portfolios that outperform key benchmarks.

My model portfolio, consisting of self-storage, industrial, residential, and net lease/retail REITs, has historically delivered superior returns compared to the VNQ ETF.

This approach emphasizes quality over quantity, offering a compelling alternative for investors seeking stable income and growth in an uncertain market landscape.

While past returns are no guarantee for anything, I believe these REITs bring qualities to the table that will allow them to keep outperforming their benchmark on a long-term basis.