After a decade of US markets outperforming almost all foreign markets, 2020 seems to have been a year where the US central bank has been far more productive in producing more dollars than the US economy has been in producing physical goods and services for those dollars to buy. Classically, these conditions that we have seen so far this year have been those that tend to lead to higher-than-average inflation, or at least lower-than-normal real returns on domestic assets. That is why I am not surprised how often I have been asked this year about how best to hedge against a potential rise in inflation and decline in the US dollar that many expect as the world digests these extra dollars. Long time readers of my viewpoints know that I don’t believe gold is a sensible inflation hedge, and believe real estate is a better “pure” inflation hedge. As we discuss in Long Run Income this week, real estate has not only tracked inflation better than gold over time (we looked at the period 1890-2020), real estate also pays you to own it while gold does not.
Vanguard’s low-cost index fund line-up offers two distinct and complementary ETFs to allocate to real estate: the Vanguard Real Estate ETF (VNQ), and the Vanguard Global ex-US Real Estate ETF (VNQI). VNQ is a US-only fund, allocated almost entirely to US real estate investment trusts (REITs), while VNQI is well-diversified across many developed and emerging real estate markets outside the US, including REITs and real estate related stocks. In this article, I will focus on VNQI while making some comparisons to VNQ.
Since VNQI’s launch in late 2010, after the 2008-2009 US real estate crash that caused a global financial crisis, VNQI’s total return has lagged that of VNQ by a significant margin. I also include the 22% decline in the Japanese Yen over the same period in this chart, since the strengthening of the US dollar against many foreign currencies, especially the Yen, was one significant factor in VNQ’s outperformance over this past decade.
Looking at current and forward-looking returns, we see that VNQI’s dividend yield is currently trading at a higher spread over VNQ’s since any time in the two funds’ history. VNQI’s dividend and yield numbers should be taken with a few packets of salt, since the non-US names in VNQI tend to be far more irregular with their dividend amounts than their US counterparts, but that won’t narrow the spread much. The 8.5% yield charted below is based on the >US$4.40 dividend VNQI paid in 2019 divided by its current ~$50 share price, while the historical trend indicates a $2.50-3.00/yr dividend assumption is more sustainable. Still, if VNQI’s diversified portfolio can sustain an annual dividend that is highly likely to remain over 5% of today’s share price, many investors will consider that a very good carry to get paid while waiting for the dollar to devalue.
As another metric of relative value of VNQ vs. VNQI, if we look at Vanguard’s advisor web pages of each, we see that VNQ is currently trading at 2.2x book value while VNQI trades at a much cheaper 0.8x book value. Although Price/Book is far from a perfect indicator of value or future returns, buying portfolios broadly diversified across almost 700 names spanning dozens of foreign markets at this yield and discount to book value has historically been a decent formula for good risk-adjusted returns.
Before increasing my allocation by too much, I first wanted to take a quick look at four of the top holdings in VNQI, one from each of the top four foreign markets captured by VNQI. When available, I will tend to center my quick views on these names by plotting the three main parts of the cash flow statements of each, which tend to provide a good big picture view on the quality and sustainability of each name’s cash flows.
Based in Germany, Vonovia SE (OTCPK:VONOY) focuses on residential real estate, and currently owns over 400,000 units. The residential sector explains the relatively stable cash flow from operations growth, while VONOY seems to have gone to the market for the third time this decade to sustain its investments. The main worry might be the debt of US$27 billion, though VONOY’s 1.25% 2024 notes are currently trading at negative yields, which makes me wonder how much we should worry about debt in names like these that may not be allowed to default.
Australia’s Goodman Group
Second on the list of VNQI’s holdings is a name that is unfortunately not on Seeking Alpha, and the YCharts data seems incomplete: Australia’s Goodman Group. In contrast to VONOY, Goodman invests in the logistics sector, one of the types of real estate that has done well in a year when more professionals have stayed home and shopped on Amazon (NASDAQ:AMZN) than gone to the office. For a chart, the best I was able to find was the below one on ASX.com showing the steady growth in Goodman’s dividend to its current level of A$0.15/share.
Japan’s Mitsubishi Estate
Next we go to Japan, VNQI’s largest country allocation, and take a quick look at VNQI’s largest position there: Mitsubishi Estate (OTCPK:MITEY). While many of the top Japanese REITs (aka “J-REITs”) tend to focus on office and retail real estate, MITEY focuses on hotels, especially hotels at many of Japan’s airports. Given that focus, I’m actually surprised MITEY’s share price isn’t further off its high, or that this name still trades at a >30% premium to book value.
In terms of cash flows, MITEY seems as solid as many other Japanese cash cows I’ve looked at, and has reduced dividends to shareholders, but has still managed to not need to issue any new shares or debt so far this year.
Hong Kong’s Sun Hung Kai
Last but not least for this article, I take a look at Sun Hung Kai Properties (OTCPK:SUHJY), which as a Hong Kong resident of 10 years I am personally more familiar with than the first three names. SUHJY is a long-established “blue chip” name here in Hong Kong with a long consistent history of profitability that has kept it in the Hang Seng Index, but it is a capital-intensive company with relatively low rates of return on capital. The chart of cash flows below, showing what seems to be a significant investment on a capital raise in this pandemic year, does make me want to take a look at its next interim and annual reports to see what this big investment might be and if it’s a project I can go and visit. SUHJY has historically been good at making opportune investments that pay off, so an optimistic investor would hope that’s what it has done this year, though also worth noting that its cost of debt capital is much higher with its bonds trading at yields closer to 5% than 1%.
Just looking at the top four holdings of VNQI, we can get a good idea of how broadly diversified this ETF is across geographies and sectors of international real estate, but also how lumpy the cash flows of many of these names can be. For an ETF with the Vanguard brand that is so broadly diversified across all these different lumps for only a 0.12% expense ratio, I believe many passive allocators will not be too bothered by how to improve on this portfolio but rather look to buy based on its relatively attractive risk/return metrics. As a rough forward-looking estimate, I might put together the following three components of VNQI’s expected total return over the next decade:
Dividend yield: 5%/year
Growth in dividend / book value: Around 2%/year
Multiple expansion from 0.8x book to 0.9x book: Around 1%/year
The “growth in dividend / book value” assumption is based on the idea that these fundamental metrics will tend to grow at roughly the same rate when measured over long enough periods of time. It is also important to note that VNQI investors will be measuring these underlying fundamentals in US dollars, so this “growth” will be more positive if the dollar weakens and could easily be negative if the dollar continues to strengthen.
Either way, without seeing any catalyst for more than a tiny handful of VNQI’s holdings to run into debt problems (which none of these top 4 holdings seem likely to have anytime soon), I see more upside than downside in this ETF, and feel fairly safe with the ~8%/year forward return estimate outlined here.
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Disclosure: I am/we are long VNQI, VNQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.