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FREL: Investments In Industrial REITs Can Generate More Value

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Fidelity MSCI Real Estate Index ETF (NYSEARCA:FREL) is a very interesting story, as almost all the major investments in this portfolio were reshuffled on October 17, 2019, almost 32 months back. Then the pandemic came, the stock crashed during mid-March 2020, and then it recorded a huge growth. Price at the end of 2021 was more than double of that of mid-March 2020.

The fund had continuous growth during that 20-month period. But, 2022 has been very bad for this fund. Price has come down from $34.94 on 31st December to $28 at present, a drop of almost 20 percent. Not surprisingly, almost all the REITs in its portfolio had negative returns in 2022. A major reason behind this is unoccupied real estate spaces.

Pre-pandemic, investors were tempted by the prospect of rental income, which has been marred by vacancy and low increments in lease renewals. As the inflation rises, interest rate increases, and recession looms in, there is an assumption that only some specific types of REIT will be beneficial to investors.

About Fidelity MSCI Real Estate Index ETF

Fidelity MSCI Real Estate Index ETF is an exchange-traded fund (ETF) that is composed of major United States based real estate investment trusts (REITs). It has recorded an average yield of 3 to 4 percent and total return of around 7 percent over the past five years. This diversified REIT ETF was launched on February 2, 2015 and is domiciled in the United States. It is co-managed by Fidelity Management & Research Company LLC. and BlackRock Fund Advisors. By using representative sampling techniques, FREL seeks to benchmark itself with MSCI USA IMI Real Estate 25/25 Index, which represents the performance of the real estate sector in the U.S. equity market,

Industrial REITs – The Safer Bet During Recession

Industrial REITs are real estate investment trusts that are involved in the management, ownership, and leasing of industrial properties, either for setting up factories, distribution centers, warehouses, or e-commerce fulfillment centers. These REITs purchase industrial buildings or acquire land and set up industrial buildings or parks on those.

The guaranteed incomes, combined with the underlying real estate assets, make industrial REITs attractive to investors. Over the past decade, one of the biggest beneficiaries of the growth of e-commerce is industrial REITs. With a growing number of consumers shopping online, e-commerce companies are setting up warehouses and fulfillment centers near metropolitan areas where a majority of customers live.

This suggests that the demand for storage and logistics services is on the rise, and it will be beneficial for REITs if they invest in strategic industrial properties, mainly warehouses. Such properties need to have easy access to transit routes. These strategic industrial properties will deliver steady growth for a longer period as they are in a better position to facilitate the movement of goods to and from manufacturers, distributors, fulfillment centers and the end consumers.

Prospects of Other REITs

However, it’s not true that other REITs have no future potential. Life in America is returning to its pre-pandemic normalcy in many ways. As a result of which, demand for travel and restaurant reservations are growing very fast. Demand for Healthcare and Residential REITs are also growing, but at a much slower pace. The major problem of those REITs is occupancy. However, over the years, these problems can be managed through matching demand and supply, and rate adjustments.

However there’s one area that is not probably going back to the normalcy or the pre-pandemic level — the office building space. In the words of Jonathan Litt, founder and chief investment officer of Land and Buildings, a real estate activist hedge fund: “I think remote work is going to be a permanent feature. I think there’s going to be a real struggle for traditional landlords.”

There is data to back this assumption. Property-technology services firm Kastle tracks key card entry to office buildings. During mid-April, it recorded that on an average 42.8 percent workers attended their offices across 10 metropolitan areas, whereas prior to the pandemic, that was almost 100 percent. Companies with older office buildings are suffering the most, as their rents are going down and expenses are going up.

Portfolio of FREL

Fidelity MSCI Real Estate Index ETF has diversified its investments over all types of REITs – Office REITs, Retail REITs, Residential REITs, Healthcare REITs, Specialized REITs, and Industrial REITs. Its top 25 investments compose 64 percent of the total portfolio. Among these, 23 percent are in Office & Retail and residential REITs. FREL has invested almost 16 percent of its fund in three communication infrastructure REITs.

FREL has invested in various REITs primarily engaged in warehousing, logistics and information management services such as Prologis Inc. (PLD), Public Storage (PSA), Weyerhaeuser Company (WY), Extra Space Storage Inc. (EXR), Duke Realty Corporation (DRE), Iron Mountain Incorporated (IRM) and W. P. Carey Inc. (WPC). The percentage of investments in these REITs are a little over 15 percent. Barring PLD, all other REITs have generated significant price growth (in the range of 3 percent and 10 percent) in the past 12 months, when FREL has delivered a negative price growth of 17 percent.

PLD is also expected to perform better and grow in the same range of their peers once the acquisition of DRE takes place. The proposed “merger is anticipated to create immediate accretion of approximately $310-370 million from corporate general and administrative cost savings and operating leverage as well as mark-to-market adjustments on leases and debt… Further, future synergies have the potential to generate approximately $375-400 million in annual earnings and value creation, including $70-90 million from incremental property cash flow and Essentials income, $5-10 million in cost of capital savings and $300 million in incremental development value creation”.

A very interesting observation about FREL’s top 25 investments is that, barring those industrial REITs, no other REIT among the remaining 18 has been able to generate a price growth in excess of 3 percent over the past one year. As I mentioned earlier, all these are very popular REITs, and most of them have generated significant growth over the past five years.

Office REITs were the worst of the lot. Equinix Inc. (EQIX), Simon Property Group Inc. (SPG), CBRE Group Inc. (CBRE), Digital Realty Trust Inc. (DLR), and Alexandria Real Estate Equities Inc. (ARE) recorded a negative price growth between 19 percent and 27 percent during the past one year. All these support the assumption that industrial REITs are safer bets during the time of inflation and looming recession.

Conclusion

In a scenario of rising inflation, REITs are generally good bets. However, investors need to be selective regarding the kind of properties those REITs possess. REITs which are less impacted by recession and in which tenants sign long-term leases, like industrial REITs, are expected to perform better than specialized, retail, and healthcare REITs. On the other hand, office REITs don’t perform too well.

Fidelity MSCI Real Estate Index ETF generated low but steady returns over a longer period of time. However, since it reshuffled its portfolio almost three years back, certain uncontrollable factors like, pandemic, inflation, and looming recession have impacted this fund and the overall REIT sector significantly. Only the industrial REITs have been able to grow during the past one year, and in case there is a recession, only these REITs are expected to grow. Unfortunately, FREL has not invested heavily in industrial REITs. So, with the current composition, I won’t be interested in including this diversified REIT ETF in my portfolio of investments.