ETF Edge - Spring Selling Hits Real Estate ETFs

Episode Date: March 1, 2021

CNBC's Bob Pisani spoke with Todd Rosenbluth, Senior Director of ETF and Mutual Fund Research at CFRA, Laton Spahr, President of SS&C Alps Advisors and Michael Arone, Chief Investment Strategist for the SPDR Americas Business at State Street Global Advisors. The rally rolls on today but a tide of rising rates is shaking up investor confidence in the stock market. Bob discusses the broader ripple effects of spiking yields and what it means for key sectors like financials and real estate investment trusts. In the 'markets 102' portion of the podcast, Bob continues the conversation with Michael Arone from State Street Global Advisors. Hosted by Simplecast, an AdsWizz company. See https://pcm.adswizz.com for information about our collection and use of personal data for advertising.

The ETF Edge podcast is sponsored by InvescoQQQ, supporting the innovators changing the world. Investco Distributors, Inc. Welcome to ETF Edge, the podcast. If you're looking to learn the latest insights on all things, exchange, traded funds, you're in the right place. Every week, we're bringing you interviews and analysis, and we're breaking down what it all means for investors. I'm your host, Bob Fassani. The rally rolls on today, but a rising tide rates is shaking up investor confidence in the stock market. We're going all out on the broad ripple effects of spiking yields and what it means for key sectors like financials and real estate investment trust.

Here's my conversation with Todd Rosenbluth, Senior Director of ETFs and Mutual Fund Research at CFRA. Latens Spar is the president of SSNC Alps Advisors. And Michael Lerone is the chief investment strategist for the Spider America's business at State Street Global Advisors. He also runs their real estate ETF. Michael, I want to talk about rates a little bit. bit and real estate, but specifically about investing in real estate using real estate investment trusts or REITs, just to make sure everybody's on the same page, could you briefly explain what a REIT is exactly and how it sort of differs from real estate investing in general?

So a REIT is a company that owns, operates, or finances, income producing real estate. So really what it allows the investor to do is share in the... income from real estate without having to buy the property, manage the property, or finance the property. More than 145 million Americans own REITs in their 401Ks or other investments that they have, other investment portfolios that they have. Yeah. And I know just on rising rates, there's some worries out there for stocks here. Now, how does rising rates affect REITs? I mean, REITs pay dividends. They compete for rates. They compete for the person who is investing based

on getting yields. What happens when rates go up and how does it affect REITs? So typically what happens because REITs are required to distribute 90% of their income back to investors, that yield is attractive. And so when rates are rising and there are other choices for reliable income. Sometimes investors leave REITs to capture kind of more reliable or more at least perceived to be safe income from that standpoint. But what's interesting here so far is that this year, as interest rates have climbed, REITs still have attracted about a billion and a half real estate or REITs in flows, more than 3% of their total asset value. And actually, prior to today's action, REITs have been outperforming the market, the S&P, by a little bit. And I think two

things are really driving that. It's the reopening trade in terms of folks expecting more people to be at malls and back in the office. And I also think it's inflation. And so typically, you know, both rents and the value of real estate goes up when prices go up. And that's attractive for a REIT holder. Yeah, what do you make of that? I mean, I know obviously there's been inflows into REITs too as well. That also is very interesting. interesting. Yeah, I think what's also very interesting is when we dig into the REITs sector, which is roughly about 2.5% of the S&P 500, you've got a split, you know, as Michael was talking about the

reopening side of things. So hotel and resort REITs are up 13% as of Friday. You've got residential rates that are up 8.5%. You've got retail rates that are up 18%, whereas office reeds and industrial rates are down year to date. a broad market cap-weighted approach that Michael's firm XLRE offers, and then you've got either an equally weighted version that Invesco offers, or you've got twists on this. NETL is an example of an ETF that focuses in subsets the marketplace from an index-based approach.

And, of course, we now have a new active ETF. Yeah, that's very important, I think. And Leighton, speaking of actively managed ETF, you've got one. Just started trading Friday. I can't believe REIT was never taken as a symbol, but apparently you guys have it. What parts of the real estate business do you think are going to deliver the best returns in 2021? Now, we obviously know the old traditional ones, the apartments, the offices, the industrial, the retail, but a lot of the business, a lot of the real movement in the last few years has been in these data centers,

in cell towers, for example. So there's some subsectors. What's interesting to you in REITS this year? Yeah, I mean, the whole thing. based after, you know, de-rating, you know, by a couple multiple points last year relative to the S&P 500, for example, that actually saw multiple expansion, you know, looks pretty good. And I think there are opportunities on both sides of a barbell where you can look at the mean reversion type trades that, you know, Todd was just talking about with retail and malls. On the value side of the

equation, we do like the apartment sector. You know, we do think as we reopen the labor mobility, the normalization of what, you know, job growth looks like. All of that's good for, you know, people moving around. And apartments will thrive, again, in our opinion. And, you know, the other side of that coin is storage. That, you know, as jobs are created and people start to settle back into a new routine, they have to move and storage and movement go together. One thing I think that's important about the dividend yield story, though, you know,

last year, that correlation between interest rates and REITs really broke down. As we saw rates plummet, REITs also underperformed. So, you know, they didn't benefit from the lower rates that we saw through most of last year. So I think that reversion this year, whereas rates started moving back up, reits outperformed, what that's pricing is an expectation of growth in rents. And, you know, when you're looking for income, you have to think about what the real income is going to be. And growth within REITs is definitely a benefit for more. more yield-oriented investors. Right.

Now, you have, this week that you're running that you just started is an actively managed non-transparent. So you guys are actively picking stocks. You're not relying on, you know, some particular index. And it's not transparent. Explain a little bit about what that means to our viewers. We see what's in the portfolio, but we don't know what the percentages are. Is that right?

And you report quarterly what the actual numbers are? Yeah, so, you know, we like to call it semi-transparent because the market can see the securities that are in the portfolio, but they don't see the exact weight that we're implementing. And the reason that is is that we run a fairly concentrated portfolio around 40 different names. Oftentimes we'll have more than a third of the portfolio in the top five names. And so obviously when we're changing our view and we're moving those active positions higher, we don't want to signal that to the market immediately. but we do want to be able to give our authorized participants and market makers enough visibility that they can successfully hedge and provide liquidity around the ETF. So semi-transparent is the label that we think through because you can see what's in it.

You can hedge it very easily, but you can't front-run it, right? So it protects the intellectual property that's in the portfolio. And so it's like a mutual fund in that you don't know exactly the point. portfolio managers doing until, you know, 30 days after the end of the quarter. But the benefits, I mean, we all know the benefit to ETF, and now we can do it with an active structure. So, yeah, that's how we think about it. You know, it's been trading for two days, so. Right. Todd, update us on actively managed non-transparent. I mean, it's become more of an issue. It's become more of a high-profile thing. Contrast the advantages and disadvantages.

You know, Kathy Woods is actively managed transparent. You can see everything that's in her portfolio. Others like this one here, you can't see exactly what's in. It's only semi-transparent. Is there advantages and disadvantages here? Well, the advantage from the portfolio manager, as was touched on, is they can move in and out of positions without having to disclose each day that they bought a little bit more of that or they're pairing back on an individual name.

We just think that actively managed equity ETFs are gaining traction. You talked about Kathy Wood, and I know you've talked about the ARC funds in prior shows. We're seeing firms like American Century and Tiro Price and Fidelity and Invesco, other large asset managers that are taking strong investment strategies and making them available from a tax-efficient perspective for ETF investors. So I think it's really exciting that we now have an active REIT approach to it, for someone who want a low-cost, index-based strategy, State Street, and others have that now active management exists in a REIT wrapper, too. Yeah.

Michael, yours is not actively managed XLR, but it has some very concentrated holdings in tower stocks, for example. I look at your most, your top holdings, American Tower, almost 12% of the entire fund here. they lease cell phone towers, essentially. Prologis is a distribution center and warehouses, so it's a little different. But Crown Castle, that's another one. That's a cell tower provider. And there's some other ones in there. Digital Realty is a data center.

Simon Property is a mall owner, so it's a little bit of a mix. Now, I know this is market-cap-weighted, but the market seems to be saying it really likes cell towers these days and it likes data centers. Yeah, Bob. So exactly right. It's a market cap weighted index. We're simply seeking to match that index. And as you're rightly pointing out, if you think about the kind of corollary here, as Apple has grown,

as smartphones have become more prevalent, and technology, Amazon, in terms of and kind of Facebook and others, not surprisingly, there's a commensurate increase in the need for communications infrastructure, for towers, for data storage. And not surprisingly, these are some of the biggest names with the index. And you mentioned a few of them, Crown Castle, American Tower, Digital Realty Trust. Now, one of the things that has been interesting, and I think Todd was describing this a little bit as well, is we have seen similar to the market this year. There has been an underlying rotation in terms of performance.

And so digital realty trust was a big winner last year as the stay-at-home stocks really did well. But since August, excuse me, since October, we've actually seen Simon Property Group climb more than 80%. It's the largest mall operator in the U.S. So as the economy is expected to reopen, as vaccine distribution progresses, folks are expecting the consumer and retail to rebound. We're starting to see that, and you could also see that Simon Property Group is one of the bigger names in the index as well. Right. So, Leighton, you've got the sort of burden of doing the active management part, and this is the hard part of active management. I think of health care, for example. There were some very successful health care managers in the 90s and 2000s, and what they had to do was rotate between managed health care, pharmaceuticals, biotech, medical devices, and how well you could maneuver in and out. of those kind of determined how successful you are, that seems to be the same thing with REITS today.

You've got the old standbys of apartments and offices and industrial centers, but you've also got data centers, self-storage, you know, what we were just talking about there. Do you have, what methodology do you follow to determine how the waitings are going to be? Can you just be a little more specific? Yeah, and, you know, the burden of proof in, in real. reits is actually a little easier to bear than in most places the equity market when we're trying to support active management. When you look over a long periods of time, 70% of active reet managers have outperform their benchmarks of the last 20 years. If you look for the

last three years, it's closer to 55%, but it's still more than half. And that's pretty unique for active management, right? Equities in general see active management underperform. And I think what allows active REIT managers as a group to do well is a focus on value. And, you know, real estate is still a mean reverting category. It's different than health care and that it doesn't have, you know, the enormously, you know, complicated regulatory structures. It doesn't have the huge innovation breakthroughs that we have that really disrupt an industry. Real estate evolves fairly gradually. And because of that, you can look at it as an active manager, and you can get a sense of longer-term trends, right? And you can play against the momentum that may take a, you know,

data center or tower stock, for example, right now to very, very big market caps. And you can start looking back at some of the areas that have lagged over the last few years, like apartments or retail. And that mean reversion is pretty powerful. So what we're looking for from a specific construction standpoint is value, right? Well, we can look at a stream of rent. And we put in some fundamental view about how those rents are going to change. And then we look at growth versus the interest rates that you have to have to capitalize real estate. And that's fairly straightforward value orientation has worked in real estate. And we think it will continue to work.

And when we look at it versus the bond market, yes, low interest rates are really critical for the financing piece of it. But if we do start to see inflation creep back into the economy, rents grow with or faster than inflation. which is the big advantage versus the fixed income portion of an allocation. So, you know, we're thinking about growth, we're thinking about value, we put them together, and it's worked. Yeah, so your basic pitch here, Leighton, and Michael, jump in a bit if you want, but is rents are growing higher than inflation right now, and that's going to ripple right across the entire rate value chain.

Is that the main point you want to make here? Yeah. I mean, we've got yields in the three to four percent range, and we think those dividends can grow, you know, four to five percent, which is faster than inflation. So from an income standpoint, we've got a nice tailwind. So just picking up on Layton's point, if you look over the last 20 years, re-dividend growth has outpaced inflation in nearly all of them. So again, as income is really scarce right now for investors, and it looks like in terms of the challenges on the fixed income side of things are going to be with us, rising inflation, rising interest rates,

which puts downward pressure on bonds, this kind of stable, reliable income stream above inflation is really attractive to investors. And I think that's part of the reason why you've seen ETFs attract flows there, and the performance is held in pretty strongly as well. To piggyback onto what we've seen from a flow standpoint, we are seeing reach among the more popular sector ETS. We have some financial ETFs that are leading like XLF and KRE, which is a regional banking ETF, but REITFs rarely are at the top of the sector leaderboard. I think it's a sign that it

fit REITFs are balancing both the growth as well as the defensive characteristics. The REITS sector has a beta of about 0.7 versus the broader market, a little bit defensive, but nowhere near as defensive as utilities or consumer staples. Yeah, I mean, you noted to that in our discussions earlier, Todd, that REITS had been successful pulling in some significant flows in the last year to date so far. Michael, I want to talk about COVID and return to offices. We haven't touched that at all or Leighton, if you have a thought on this. What is going to happen? I mean, the rollout of the vaccine is accelerating rather dramatically now. We are seeing a third vaccine that will be start delivered to be delivered within the next week or two. It seems like the

reopening is really proceeding apace. This is why the reflation trade is doing so well. Certainly by May, a significant part of the population is going to be vaccinated. What is the REIT industry saying about the return to offices at this point? How are they preparing for that? And is it going to be somewhere in the middle of people going back full time and part-time? Right. I think that we will be getting more people in offices as the year progresses, as vaccines get more widely distributed. We're not going back to the pre-pandemic kind of way of life anytime soon. So, you know, there will still be fewer people in those offices. I think companies have sought to do a number of things to more efficiently manage their businesses, including their real estate footprint. And that trend's likely to continue and put some downward pressure on the office reits in particular moving forward.

But you could see some kind of snapback mean reversion, as Leighton was describing, in terms of as the economy recovers and more people get back, that should help. But I think we're a long way away from being kind of a position of strength. Yeah, that's the one sector. Laten, don't you see underperforming for a while? how you can make an argument that rents are somehow going to go up in the office space area. Are you not making that argument in this particular subsector, are you? No, I mean, we're similarly cautious on office. And, you know, the people that are most optimistic about the recovery and office space

are the landlords of those office spaces. And, you know, when we talk to CEOs that are not in the Reed industry, you know, I think they're much more cautious about what they're going to do with their office footprints. You know, I was actually talking to a CEO that was testing this theory that FaceTime is going to matter again, you know, and there's a competitive push to be back in the office. And everybody else in the conversation, you know, kind of said, I don't see that happening. You know, that young people in particular, you know, they make their influence online as well as they do in person. So, you know, I think some of these behavioral changes around how work is done and where's work is done are long term.

So we're not a big mean reversion trade within office space, you know, but we do think in retail and malls, you know, there's some innovative ideas of how to make those spaces functional again. And that ties back into industrials, right? And the omni-channel movement of goods around the world needs space. And, you know, malls can be repurposed for a lot of things. They're fairly general. They're located all over the place. So if you're going to play Deep Valley, we like retail and malls better than we like office. Yeah, I, I, you could just look at a, I don't know, pick one of them, Boston Properties, for example.

Those office reeds have notably underperformed, even XLR, for example. So I think that's a hard argument to make. I can certainly see how you can make an argument of rising rents in storage, rising rents, in the prologists of the world, data centers, anything like that can certainly, even towers, I think we make an argument for rising rates, rents. I don't see that in the office space. Guys are going to have to let it go with that. Interesting discussion, as always. That's it for this week's ETF Edge. And thanks to Todd, as always, and to Layton and Michael. Now it's time to round out the conversation with some analysis and perspective to help

you better understand ETFs. This is the Market's 102 portion of the podcast. Today we'll be continuing the conversation about the state of real estate with Michael Lerone from State Street Global Advisers. Thanks for sticking around and chatting with a little more, Michael. The one thing I didn't get a chance to ask you in the ETF Edge broadcast is the tax treatment of real estate investment trusts. There are some positive advantages of there as well. Can you explain that to us? So, Bob, I think we did cover off on this idea that the economy should reopen. That should help.

Inflation is a tailwind for REITs. One of the things that we didn't cover in that was that if you expect the Biden administration to raise corporate taxes in 2021, and I think it's likely given the fact that they're going to have to get some revenue to help fund some of this fiscal spending, including the infrastructure plan, one of the ways they might do that is raising corporate taxes. What's interesting is REITs, because of their structure, if they distribute 90% of their income, which they're required to do, they avoid paying corporate tax rates, corporate taxes. So as a result, they have a lower effective tax rates than many other sectors. So as investors maybe seek out more tax-advantaged investments, REITs could be a natural beneficiary through that trade.

So suss that out for us a little. Is it the case that a company like a Simon property group, for example, or a prologist, doesn't really pay any corporate taxes or is it just they pay less taxes? What do they actually pay? So they pay taxes, but not on the income they distribute, which is ultimately what the kind of investor wants. Now, the investor gets taxed on ordinary income or capital gains and things on that income. But the corporation itself pays a much lower effective corporate. tax rate. And that could be if corporate taxes are going up, could be another reason to own REITS. Admittedly, it's not the overwhelming kind of reason to own them, but it could be a kind of a secondary peripheral benefit. Should corporate tax rates rise, REITs, you know, their corporate tax rates will stay the same. Does the State Street have an opinion on this? Is it, is it your opinion, personally, or the company's position that it's likely we're going to see corporate taxes rise in the next

year or so? Well, I think Biden's made it clear that he's likely to raise taxes in order to fund additional spending. And one of the things he ran on was raising the corporate tax rate from around 21 percent, I think upwards to 28. He probably won't get all away there given the division in Congress, but it's likely that corporate tax rates are going up. I wouldn't categorize this as State Street's opinion, but more of my own. Yeah. You know, the most common question I get from viewers, days, believe it or not, it's not what sectors I should invest in, you know, should I be in banks or reeds or utilities or anything else on that. They're very concerned about the tax situation. They're concerned about higher corporate taxes, but they're also concerned about

personal taxes going up. So a lot of the viewers of CNBC are in the higher tax bracket at 37%. They're worried about it going to 39%. And a lot of them have a lot of their retirement money in 401ks. So as they get older and they start pulling out money, money, They may be in a higher, be paying more out as well for that. And so I think you're going to see, you know, when tax advantage strategies really start showing up on people's radars, I've had a lot more questions about, for example, Roth IRAs and using that as a way to save money rather than a 401K,

because obviously if you're in a 401k, a pre-tax account, you're going to be pulling that out at potentially higher rate in the years to come. So I don't know if State Street has any commentary or advice for people in that situation, but that's the number one question I've been getting in the last three months. Right. I think investors and corporations are expecting taxes to increase, and that's almost regardless of political affiliation. Given the massive deficits that we have, they need to be addressed. And one of the ways to address them is by raising taxes.

And it seems like raising taxes on the higher income brackets is kind of the most politically, you know, favorable or kind of the most politically convenient at this point. And so I do agree with you, Bob. I think that the demand for tax-shielded, tax-sensitive assets is going to increase. One of the ways we primarily see that is through investing in municipal bonds. And so that continues to be an area that despite very compressed yields, you continue to see folks invest in municipal bonds for those high tax-equivalent yields, given the tax treatments of munis from that standpoint. Now, as part of fiscal stimulus plan, you're going to see

hundreds of billions of dollars go to state aid. That should shore up some of the more challenging kind of fiscal elements at the state level and should give folks maybe further confidence in the municipal bond market. Yeah. The real estate, the REITF that you run, XLRE, is a market-cap-weighted reed. But do you have any personal thoughts on what sectors you think? might be outperforming. The market seems to be saying that, you know, cell towers, for example, and data centers are the hot investment. That makes some sense. Obviously, office is not. But do you have any sense on, is there anything that's going to surprise us this year in real estate, some sector to come out of nowhere, like managed health care or something like that?

It could be. I mean, I do think it is about striking that balance, that barbell. I would agree. I think that data centers, communication infrastructure, that will continue to be an area that does well, has high rates of growth as the economy becomes more and more digital, more technology prevalent throughout. But I do think that some of the surprises could be on the health care reed side of things. You could start to see as demographics are shifting, given some of the impacts of the pandemic, those types of things. Healthcare reeds could be a kind of a surprise outperformer in 2021. Okay, Michael, I'm going to have to leave it there. I always appreciate your thoughts and State Street's thoughts as well. Interesting that REITs are doing so well and there's been so much demand for them. We've been talking to Michael O'Rone from State Street Global Advisors and, of course, he also runs that REIT, that they have their XLRE is the symbol there if you want to check that out.

Michael, thank you very much. And again, everybody at the healthy, happy and safe trading week. InvescoQQQQQ believes new innovations create new opportunities, create new opportunities. Here's the greater possibilities together. Learn more at Invesco.com slash QQQ, Invesco Distributors, Inc.