By Salvatore J. Bruno, Chief Investment Officer, IndexIQ.

Salvatore Bruno, Chief Investment Officer at IndexIQ.

While they’re straightforward on the surface, when you look beneath the hood, real estate investment trusts (REITs) can quickly become more complicated.

At their core, they acquire properties and generate income from leases, passing on that income to shareholders. Large-cap REITs generally own larger properties; small-cap REITs smaller ones.

ETFs like the IQ US Real Estate Small Cap ETF (ROOF US) invest in multiple REITs based on the rules of an underlying index. In the case of ROOF, the average market cap of the REITs in the fund was just under $2 billion on 31 May 2019. That compares to an average market cap of over $26bn for large-caps.

Small-cap REITs have tended to carry higher yields than their large-cap counterparts. For ROOF, the 12-month yield was 6.54%, as of 31 May 2019. This compared to a yield of 3.85% for the FTSE Nareit US Real Estate Index during that same period. REITs are required to pass along at least 90% of their income annually to shareholders.

REITs are generally valued on a metric called “funds from operations,” or FFO. FFO is calculated by adding depreciation and amortization to earnings and then subtracting the value of any sales. It’s effectively the cash flow generated by the REIT and represents money that can be paid to shareholders in the form of dividends. Dividing the REIT share price by FFO gives you a ratio that can be used to compare the valuations of REITs across property types (apartments and office buildings, for example) and market caps, much like a price-to-earnings ratio.

A look at the current FFO ratios for large and small-cap REITs shows that small-caps are trading at a substantial discount to large caps: 12.6x compared to 17.3x, as of 31 March 2019. The last time the ratio was lower was in March of 2016. Over the next 12 months, small-cap REITs (ROOF) outperformed large-cap REITS (Vanguard Real Estate ETF (VNQ US)) by over 1000 bps.

There are a number of possible reasons why this discount has widened. For some investors, REITs may have proven an attractive way to potentially sidestep the negative impact of trade wars, assuming the properties are domestic and the cash flows are generated in the US These individuals may have gravitated to the large-cap sector, pushing prices and valuations up. There may be concerns that smaller properties are more vulnerable to an economic slowdown, again causing investors to move towards large-cap.

While there’s no one obvious reason, the data is clear: based on historic valuations, small-cap REITs are trading at an unusual discount and, at the same time, are offering substantially higher dividends than large caps. How long this dislocation will persist is anyone’s guess, but it suggests that small-cap REITs are currently worth a close look. Yields are attractive and, should the valuation gap be closed through small-cap appreciation, there could be an opportunity for capital gains as well.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)