Outside the Box: High-priced REIT shares are creating problems for index funds

Consider these investment questions: If you own shares of all the stocks in a particular sector or industry, do you want to see all the underlying companies flourish? Or do you want to have a perpetual state of some killing off others — to the ultimate benefit of consumers?

And if you have so many assets that you own large percentages of all the companies’ shares in a sector or industry, do you necessarily support the stock prices of weaker players who would otherwise be forced to improve or exit the market?

These are compelling questions veteran Philadelphia Inquirer reporter Joseph DiStephano raised recently in an excellent article about mutual-fund giant Vanguard Group’s increasing domination of the publicly traded REIT market.

The Vanguard REIT Index fund VGSIX, +0.54% and its lower-cost Admiral shares sibling VGSLX, +0.56%   currently contain around $65 billion in assets, according to investment researcher Morningstar, while the Vanguard REIT ETF VNQ, +0.57% has another $34 billion in assets. Altogether, Vanguard has a cool $100 billion in these funds, which is more than 10% of property REITs’ entire market capitalization of almost $1 trillion.

This doesn’t even count the REIT shares Vanguard owns in its broadly diversified funds such as the Vanguard 500 Index Fund VFINX, +0.58%    and the Vanguard Total Stock Market Index fund VTSMX, +0.65%  , which together have close to $1 trillion in assets.

REITs comprise roughly 3% of the U.S. stock market, meaning these two diversified Vanguard funds have an additional $30 billion in REIT stocks. That takes Vanguard’s stake up to about 13% of the entire REIT sector.

Now add the ETF versions of those two broadly diversified funds and that’s another $150 billion in assets, bringing Vanguard index funds’ ownership to more than 15% of the REIT sector. As DiStephano reports, if you include BlackRock’s BLK, +1.28%  and other index providers’ holdings with Vanguard’s, index funds own around 30% of all publicly traded property REITs.

Will big REIT index funds now have to own non-REITs?

One problem with this is that index funds buy and sell shares mechanically, without evaluating the companies whose stocks they’re trading. Previously, by contrast, there was “a ‘mafia’ of specialized investors who pressed REIT managers when returns lagged,” as DiStephano quotes Janney Montgomery Scott analyst Robert Stevenson. Investors who knew the sector would also prevent management teams from oversupplying markets with new construction.

Moreover, it may be tougher now for REITs to go public if they are not large enough to get into the small-cap and dedicated REIT indexes. Currently, REIT index investors may be indiscriminately buying properties whose values are flattening at a time when interest rate hikes might hurt the sector.

Besides the lack of pressure on management and mechanical trading, there is some risk that Vanguard may violate REIT laws that end REIT tax protections when a 10% or more mutual fund owner also owns 10% or more of a REIT tenant. Because Vanguard’s ownership is scattered among different funds, so far it hasn’t triggered this problem. (Real estate companies organized as REITs must pass 90% or more of net income to shareholders in exchange for tax-free status at the corporate level.)

However, Vanguard recently asked shareholders to allow its REIT Index funds to buy more real estate-related companies not organized as REITs. In other words, Vanguard effectively is admitting that its REIT index funds can no longer remain completely tied to a REIT index and must track a broader index that includes non-REIT real-estate operating companies.

DiStephano’s article quotes Jeffrety DeMaso, research director at Adviser Investment in New York, saying: “When you own all the landlords, competition among them — in which REITs might improve properties and cut rents to attract the best tenants — starts to look not like a natural part of a free-market system favoring the best property managers, but like a nuisance that eats into owners’ total profits.”

Vanguard denies that concentrated ownership creates stock-price distortions, according to DiStephano, but clearly the desire to track a broader index means that REITs are getting too big for the funds’ mandate.

Is indexing to blame?

If the current trend continues without a serious market correction, Vanguard may have to close its REIT index funds to new money, even if they become broader real estate funds, to avoid violating the 10% REIT ownership rule. Although that would be noteworthy, it isn’t clear Vanguard would deserve blame for price distortions. Investors will find vehicles through which to buy shares in any case.

It’s true that index funds tend not to pressure companies and can’t sidestep the most egregiously overpriced stocks. But many actively managed funds aren’t terribly active in terms of both their portfolio choices and in how they interact with company management teams. They wind up hugging an index anyway — and for a much higher fee than index funds.

Yet the real problem may be with investors who continue to throw money at high-yielding sectors like REITs without considering valuation.

Now read: 3 ways to invest in a crowdfunded real-estate project

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