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The U.S. Real Estate Investment Trust (REIT) industry has carved a niche for itself and is now an important part of the overall economy. Amid the low interest rate environment following the financial crisis, the demand for REITs has risen owing to their ability to deliver steady income. Moreover, they help investors benefit from their capital appreciation opportunities as well (Real Estate ETFs: Unexpected Safe Haven).

Though the economic uncertainty and particularly the political situation have been major factors impacting the market, we believe that with the economic recovery gaining momentum, rents and occupancies for most types of properties would improve further.

In fact, it has been noticed that the residential real estate market has improved and commercial real estate prices are also increasing. And with more jobs in the economy, the sector should experience increasing rents and higher occupancy.

Additionally, in the Apartment sector there have been improvements, yet minor hiccups remain with an increase in supply in certain markets. The Industrial sector is projected to benefit from the improving economy while the Timber sector’s performance would gain from an increase in new construction. In a nutshell, the long-term prospects of the REIT industry look favorable.

A combination of factors has helped the REIT sector stand out and gain a strong foothold over the past 15 to 20 years, the most notable among them being a healthy dividend payout. As a matter of fact, investors looking for high dividend yields have historically favored REIT stocks (4 Excellent Dividend ETFs for Income and Stability).

In fact, solid dividend payouts are arguably the biggest enticement for REIT investors as U.S. law requires REITs to distribute 90% of their annual taxable income in the form of dividends to shareholders (in order to maintain certain tax advantages).

In addition, REITs typically have a large unencumbered pool of assets, which could provide an additional avenue to raise cash during a crisis. These assets, in turn, have provided the requisite resources to the REIT industry to make strategic acquisitions over time to fuel its inorganic growth engine.

Going forward, we believe M&A opportunities will increase in the current low interest rate environment. Particularly the REITs with a solid balance sheet and reasonably better accessibility to capital are expected to capitalize on such opportunities.

ETFs in Focus

In order to capitalize on these encouraging trends in the U.S. REIT industry, the ETF world has in its offering quite a few funds. Vanguard REIT ETF (VNQ), iShares Dow Jones U.S. Real Estate Index Fund (IYR) and SPDR Dow Jones REIT ETF (RWR) are some of the popular names in this space.

While these represent some of the common ways to target the U.S. REIT industry, there are still many others which have been strong performers this year. In this article, we would like to focus on two that have been designed to provide exposure to the small cap segment of the industry and are usually overlooked by investors.

Why Small Cap REIT Stocks?

As the real estate market recovers, small cap real estate ETFs are poised to benefit enormously from the current market environment, implying that they could continue to outperform their large cap counterparts as the year progresses.

This is because small caps are less vulnerable to global trends, tend to do better on average in rising markets, and can potentially offer a different sector mix than their large cap peers in changing markets (Small Cap Real Estate ETFs: Crushing The Competition).

On the other hand, large caps are multinational firms that are highly exposed to international markets and economic volatility. As large cap firms have already reached their maturation, they have little ability to expand further, thereby returning less.

Hence, small cap real estate ETFs could be considered the best option for investors seeking to play in the current real estate market. Further, small cap real estate ETFs often pay outstanding dividends when compared to other large cap counterparts, suggesting that they could be excellent picks from this view as well.

PowerShares KBW Premium Yield Equity REIT Portfolio (KBWY)

As the name suggests, KBWY follows the KBW Premium Yield Equity REIT Index. With its main focus on small and mid cap REIT securities, the fund seeks to provide exposure to a small basket of 34 securities (3 Excellent REIT ETFs You Should Not Ignore).

Despite the narrow exposure, the fund does not appear to be concentrated in the top ten holdings. The top ten holdings have a share of 36.25% in the fund.

The fund manages an asset base of $89.3 million and appears to be light on volume at just 21,900 shares a day. KBWY charges investors a fee of 35 basis points annually and generates a yield of 4.82% in the process.

The fund has been a strong performer providing a gain of 20.28% in the year-to-date period. So, apart from investing in the usual suspects, investors can also opt to invest in this fund and gain higher returns as well.

IQ US Real Estate Small Cap ETF (ROOF)

ROOF seeks to replicate the performance of the IQ US Real Estate Small Cap Index, which is a float adjusted market cap weighted index. The fund manages an asset base of $51.8 million.

However, the fund is less liquid as it trades only 31,500 shares per day on average. This illiquid nature of the fund might raise the liquidity cost in the form of a wide bid/ask spread.

Though the product charges a higher fee of 69 bps per annum from investors, it yields about 3.37% in annual dividend and has returned 18.51% year to date (Three Great ETFs to Buy This Earnings Season).

The ETF is widely spread across several real estate markets — mortgage REITs, office REITs, retail REITs, specialized REITs, hotel REITs, diversified REITs and residential REITs.

Not only does the fund have a wide exposure to different REITs, it also has large diversification benefits with respect to individual holdings. With a basket of 55 securities, ROOF allocates about 37% in the top 10 holdings, with no more than 4.6% in any one firm.

Investors should also note that this product is more heavily tilted towards value and mid caps suggesting that for investors looking to go beyond large caps, this product could be an interesting pick.

Bottom Line

To sum up, we firmly believe that, given the current recovery of the economy as well as the low interest-rate environment, REITs still offer a worthy investment proposition for 2013.

Additionally, history reveals that small cap real estate can be a solid pick when markets are rebounding. And even when the sector is seeing some weakness, its outsized yield is likely to help soothe investor worries and make ROOF and KBWY a great pick no matter what the market conditions are.

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ISHARS-DJ REAL (IYR): ETF Research Reports
 
PWRSH-K PY REIT (KBWY): ETF Research Reports
 
IQ-US RE SC (ROOF): ETF Research Reports
 
SPDR-DJ W REIT (RWR): ETF Research Reports
 
VIPERS-REIT (VNQ): ETF Research Reports
 
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