FREL: Average, But Still A Hold For The Upcoming REIT Rally

The vast majority of REITs have been dead money this year and the dividends don’t make up for fading share prices. This is sector-wide and is reflected in the performance in ETFs such as the Fidelity MSCI Real Estate Index ETF (NYSEARCA:FREL).

REITs are one of the worst performing sectors this year, but that does not take the sharp rally from October – December ’23 into account. FREL is still around 18% above the October ’23 low and looks to be consolidating the 26% rally made in this period. I think it is a matter of time before it takes off again.

A Strong Correlation

The October-December ’23 rally in REITs mirrored the rally in long-term bonds. Indeed, FREL’s correlation with high duration bond ETFs like the iShares 20+ Year Treasury Bond ETF (TLT) is high; FREL rallied 26% in Q4, while TLT rallied 22%.

Since the December peak, both funds have drifted lower, but FREL has shown some relative strength and has held up fairly well. This is important as we are looking for steady price action. FREL is forming a sideways consolidation, which should set up the next phase of the rally later this year.

The drivers of the correlation and the price swings are quite simple: REITs are very sensitive to interest rates.

The reasons behind this are more complex, as there are multiple explanations for the correlation, at least from a fundamental perspective. REITs tend to have high debt levels and this is a headwind when rates are high. They also depend on the economy and the real estate market, both of which tend to struggle in high rate environments.

That all said, the number one driver, at least at this time, is yield. REITs are primarily seen as income investments and therefore have yields comparable to the risk-free rate as provided by a 10Y UST.

Obviously, REIT distributions do not change too much from year to year, so the yield is mostly a factor of price changes.

The Case for REITs

Given the correlation highlighted above, the case for REITs heavily depends on long-term yields coming down. Thankfully, that process looks to be underway. The Fed’s first dovish shift happened last November as inflation fell to around 3%. That created an overreaction in markets, which swiftly priced in up to six cuts in 2024 starting in March. Needless to say, that caused a huge reaction in bonds, REITs and most risk assets. Unfortunately, the expectations were way too optimistic, and the Fed is yet to cut at all. This led to the pricing out of dovish expectations, and this has obviously been a weight on REITs over the course of the year.

Despite the disappointing lack of follow through in 2024, the market’s overly dovish or hawkish expectations shouldn’t alter the fact the Fed will almost certainly cut this year, whether it is due to falling inflation or weakness in the economy. This should set up a second leg higher in REITs and all related assets.

While the wait for the Fed’s first cut and the second rally in REITs is taking longer than most expected, holding a steady REIT fund like FREL means we can position for the move in advance. It may drift slightly lower, but at least earn a small dividend while we wait.

Introducing FREL

FREL was launched in 2015 by Fidelity. It is a passively managed ETF with $966M AUM which seeks to track the IMI Real Estate 25/25 Index. The Index is a “modified market capitalization-weighted index that captures the large-, mid-, and small-cap segments of the USA market. All securities in the index are classified in the Real Estate sector according to the Global Industry Classification Standard (GICS®).”

The weighting employed by the Index ensures diversification.

The index restricts the weights of the group entities such that no group entity exceeds 25% of index weight and all group entities with weight above 5% cumulatively cannot exceed 25% of the index weight.

The selection process leads to a familiar top 10 holdings with weighting up to 7.6%.

The top 10 make up 44% of the portfolio, which is common among REIT funds.

Indeed, there is very little difference between the major funds, and they are very closely correlated due to their similar holdings.

There is scope to outperform, in say USRT. FREL’s performance is average, and slightly beats VNQ over the past year.

FREL has an attractively low expense ratio of 0.08%. The dividend yield of 3.62% is reasonable and is only beaten significantly by VNQ, which as we saw above, loses on a total return basis.

To conclude, FREL is average across most metrics. You could find better performing REIT funds, but the stand-out performer, USRT, has a dividend of only 3.24%. FREL sits nicely in the middle and is a decent fund to position for the next REIT rally.

Conclusions

REITs have been drifting lower to sideways in 2024 in a move which should be consolidating the large run-up in Q4 last year. This is healthy action as it should set up the next phase of the rally when the Fed inevitably shifts more dovish and starts cutting rates.

FREL is a decent fund to position for this move. It is average in many metrics, and while it has performed poorly in 2024, its performance is comparable to other REIT funds and the 3.62% dividend is attractive. I rate it a hold.