Real Estate ETFs: The Party is Over

ETFs Have Changed Wall Street into the Largest Casino of Them All

Written by Keith Jurow, Capital Preservation Real Estate Report

Chairman Ben Bernanke finally warned us that the QE 3 party is coming to an end. All fixed income securities dropped and interest rates spiked.

Shares of all the mortgage REITs also plunged in price. In the second issue of my Capital Preservation Real Estate Report, I had warned that this decline in share prices was likely to occur.

As of August 19, share prices of many mortgage REITs are down by 35-50%. Investors are hoping that the worst is over. Let me assure you that the collapse is far from over.

ETFs and the Wall Street Casino

In less than 20 years, ETFs have changed Wall Street into nothing less than an enormous casino for traders and speculators. John Bogle – the founder of the Vanguard Group – feared that this would happen when the idea for ETFs was first presented to him. In his view, giving investors the ability to take positions and trade in index stock funds would turn long-term investors into short-term traders. Was he right!

While investors pulled roughly $460 billion out of traditional equity mutual funds since 2007, they poured an incredible $680 billion into equity ETFs during the same period. Out of the total amount traded in equities in the past year (in dollars), about 40% were ETF trades.

Investors just love the ease and convenience of taking positions in an index fund that covers an entire sector “all day long and in real time.” The fact that the ETF only “tracks” a particular Index doesn’t bother investors in the least.

Should investors in real estate ETFs be concerned? Absolutely! Let me explain why.

The Real Estate ETFs

The oldest of the real estate ETFs is iShares Dow Jones US Real Estate Index Fund (IYR). It began operations in mid-2000. The largest REIT holding in the fund is Simon Property Group – the biggest owner of shopping malls in the nation.

The share price of this ETF rose sharply as the commercial real estate boom unfolded in 2004 – 2007. The price went from a low of 43 in April 2004 to a peak of 92 in January 2007.

The rather strange thing is that the volume of shares traded did not rise significantly in 2005 – 2006 as the ETF headed for its top. Weekly volume at the top in early 2007 was only 13.1 million shares, not much different from the previous two years.

Then as the share price began its long descent, volume soared. With the price hitting 78 in September 2008, weekly volume had reached 174 million shares. As the credit crisis unfolded, the share price plunged to 34 in early December 2008 and weekly volume had soared to 264 million shares. The price finally bottomed at 21 during the week of March 2, 2009.

Amazingly, weekly trading volume averaged over 200 million shares between February and April 2009.

What sense can we make of this incredible rise in volume as the shares plummeted in price? As I see it, those who had invested in this ETF for long-term purposes on the way up were wiped out on the way down. Their place was taken over by day-traders and other speculators who were also mercilessly mauled until the price finally turned upward.

The Serious Risks Today With Real Estate ETFs

Since early 2009, iShares DJ US Real Estate Index Fund has climbed steadily in price. It peaked at 76.2 on May 22, 2013. In the 4^th issue of my Capital Preservation Real Estate Report, I warned investors about the dangers of owning this ETF and the equity REITs. This ETF then plunged to 61 on August 19.

In that 4^th issue, I provided an in-depth discussion of the weaknesses of the major equity REITs that compose the iShares ETF.

Let me give you an example.  As I mentioned, the largest REIT component of the iShares ETF is Simon Property Group (SPG). By the end of 2012, its share price had climbed from around 30 at the bottom of the crash to more than 150. Last year, Simon purchased nearly $5 billion in commercial real estate and its holdings exceeded $34 billion by year end.

SPG is heavily leveraged and was paying 5.33% on its fixed rate debt of $20.8 billion, but investors did not seem to care. They were desperate for yields that exceeded US Treasury securities and the SPG dividend did just that.

By May of this year, the SPG share price had climbed to 182 even though net income per share dropped to $0.91 in the first quarter from $2.18 a year earlier. How can such a sky-high P/E ratio be justified?  It cannot.

Optimism of REIT Investors Has Soared

This chart shows how optimistic commercial real estate investors were about all sectors of the market in early 2013.

Source: Marcus & Millichap
Click to enlarge

Nearly 37% of those surveyed thought that it was a good time to invest in public REIT stocks. This is not surprising since nearly 60% of investors who participated in the survey believed that commercial property values have bottomed out.

The important question for you is whether this unbridled optimism is justified. My reading is that most real estate investors have bought into the view that the economy is slowly but steadily improving and that the worst is over.

They are wrong. The worst is yet to come. To find out why, check out my Capital Preservation Real Estate Report here.