VRE: Not Just a REIT Index ETF (VNFTF)

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Author’s Note: All figures listed are in Canadian currency, unless otherwise noted.

For my third review in my Vanguard Canada fund series, I’m taking a closer look at Vanguard’s FTSE Canadian Capped REIT Index ETF (TSX:VRE:CA). Yes If you’ve ever purchased real estate, you know how important a pre-sale inspection can be. Taking a careful look at what lies below the surface can help buyers avoid costly mistakes. There are several REIT ETFs offered in Canada that track different benchmarks and each have slightly different objectives.

The stated goal of VRE is a:

Track, to the extent reasonably possible and before fees and expenses, the performance of a broad Canadian real estate stock index that measures the investment performance of publicly traded securities in Canadian real estate. Currently, this Vanguard ETF seeks to track the FTSE Canada All Cap Real Estate Capped 25% Index (or any successor thereof).

VRE is a passively managed fund that directly owns 19 publicly traded Canadian companies. The fund is approaching ten years since its creation in November. VRE has assets under management of approximately $255 million. The fund is thinly traded with an average daily volume of 6,800 units.

Bottom Profile

Bottom Profile (Vanguard)

Why own a REIT ETF?

Historically, investing in Real Estate Investment Trusts has produced strong capital gains and consistent free cash flow distributions. Over time, REITs have generated total returns comparable to other broad stock classes, while outperforming fixed income. REITs tend to be less correlated to other asset classes, which can be a useful feature to dampen volatility in a portfolio.

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Other attractive qualities of REITs include stable monthly income and ownership of finite tangible assets. Investing in real estate is easy for the average investor to understand, as REITs pay out excess cash to shareholders. Real estate is a major market segment, and REITs are a convenient way to gain that exposure. Like individual stocks, investors can own stocks outright or seek out an ETF to facilitate diversification and rebalancing. In Canada, several providers offer REIT ETFs, including: iShares, BMO Global Asset Management, Vanguard, and CI.

Real estate investment trusts are one of the few publicly traded income trust structures in Canada. REITs were exempt from the conversion of income trusts into corporations in the early 2000s. The modern REIT structure was created in Canada in 1993 as a tax-efficient vehicle for the listing of public real estate companies. According to the advisory service. thornton grant:

REITs offer certain tax advantages to encourage this investment. In Canada, a REIT does not pay taxes on the income and profits from its property rental business. Instead, shareholders pay taxes on the income from a REIT’s ownership when it is distributed, and some investors may be tax-exempt.

Distribution income

VRE pays a monthly distribution of $0.09434 per unit. At current levels, the fund is projected to pay a total annual distribution of approximately $1.13, for an annual return of 4%. In 2021, VRE’s total distribution per unit was about half revenue (and foreign revenue) and half return of capital.

Holdings

VRE has 19 total holdings, with the top ten representing 72% of the fund’s net asset value. This relatively small set of holdings is not a sufficient diversification of a portfolio; however, it is more diversified than the average investor’s ability to hold a basket of REITs outright.

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Stock table

Stock table (Vanguard)

On a sector weighting basis, VRE is well diversified across sub-sectors and industries. Retail, unsurprisingly, represents the largest share of the sector with RioCan (RIOCF, REI:UN:CA), SmartCentres (SRU.UN:CA, CWYUF) and Choice Properties (CHP.UN:CA, PPRQF) accounting for they are some of the largest REITs in Canada. VRE’s main holding company, Canadian Apartment Properties REIT (CAR.UN:CA, CDPYF), is one of the best managed REITs in Canada; however, its historically premium valuation has resulted in lower overall performance. I’ve covered RioCan REITs, Choice Properties, and Canadian Apartment Properties individually, in case you’re interested in taking a closer look at these properties.

Subsector Table

Subsector Table (Vanguard)

While the term “REIT Index ETF” is found in VRE’s title, the fund’s holdings are actually broader than just real estate investment trusts. VRE tracks a real estate index, not a REITs index. Although it is primarily made up of REITs, the FTSE Canada All Cap Real Estate Index Capped 25% it also includes the Real Estate Services and Real Estate Ownership and Development subsectors. While this may be a subtle distinction, it has a material impact on the characteristics of the portfolio and VRE constituent parts, including VRE distribution performance.

The lower relative performance of VRE is the result of the inclusion of real estate services companies in FirstService Corp. (FSV:CA) and Colliers International Group Inc. (CIGI), which pay less than 1% dividends. Both are interesting companies with exposure to the real estate sector through service revenues; however, they differ from REITs in that they do not pay the majority of their cash flow to unitholders. VRE also includes real estate developer Tricon Residential Inc. (TCN:CA, TCN), which is underperforming 3%.

Comparing VRE with its peers

The other big REIT ETFs in Canada are BMO Equal Weight REIT ETF (ZRE:CA), iShares S&P/TSX Capped REIT ETF (XRE:CA), and CI Canadian REIT ETF (RIT:CA). BMO’s ZRE tracks the Solactive Equal Weight Canada REIT Index, while both XRE and RIT track the S&P/TSX Capped REIT Index. Since RIT tracks the same index as XRE and charges 20 basis points more in management fees, I will focus comparisons on the BMO and iShares funds rather than CI’s RIT.

Fund Comparisons

Fund Comparisons (Vanguard)

Of the three funds, BMO’s ZRE has the highest return at 5.22%, while VRE and iShares XRE are just over 4%. BMO’s equal weighting formula contributes to ZRE’s higher performance relative to VRE and XRE. The increased representation of smaller market cap REITs with higher yields has a positive impact on the fund’s total return.

Compared to the other funds in this category, VRE has a smaller market capitalization, with only half the NAV of ZRE and less than a third of XRE. Where VRE excels, however, is in its fee structure, with an administration fee that is 20 basis points lower than its closest competitor. When this higher MER is factored in, it more than offsets the 15 basis point performance difference between the Vanguard and iShares funds.

Risk analysis

Looking at long-term averages for the Canadian REIT sector, current prices offer a deep discount to NAV and a P/AFFO that is in line with historical averages. Overall, the REIT sector appears undervalued and still offers an attractive yield premium relative to fixed income.

REIT Sector Valuation Table

REIT Sector Valuation Table (RBC Capital)

The key risk for short-term REITs is rising interest rates. As of Q3 2022, the cost of five-year commercial mortgage debt was 5.2% and ended up over 260 basis points from Q4 2021. With central banks still on a tightening trajectory , borrowing costs could continue to rise for REITs even as fixed income rates become more attractive.

All things considered, the current NAV discount across the REIT sector provides a comfortable safety margin for the current entry level. While it’s difficult to assess the risks of all the underlying assets, diversifying an ETF provides additional security here. Of the large REIT holdings represented in VRE, the vast majority are rated BBB or higher.

REIT Industry Credit Ratings

Credit ratings of the REIT sector (RBC Capital Markets)

Investor Conclusions

Vanguard’s FTSE Canadian Capped REIT Index ETF is a good choice for a low-cost vehicle to gain exposure to the Canadian real estate market and generate stable monthly income. The inclusion of VRE from real estate service companies within the fund results in a lower return than other comparable funds. However, this inclusion provides diversification to other subsectors of the real estate sector. If overall performance is your goal, then there are better funds to consider than VRE.

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