Indexonomics

Dow Jones U.S. Real Estate Index
September 8, 2016

Passive investing in real estate offers diversification. But it comes at a hidden cost

The DJ US Real Estate Index tracks the value of Real Estate Investment Trusts (REITs) and other companies that invest directly, or indirectly, in real estate through development, management, and ownership. The index includes 117 companies with a range in market capitalization between $600 million to $67 billion. As of the second quarter of this year, the index trailing price to earnings ratio was 30.5 times and price to book value was 2.6 times. Not cheap.

At least management expense is minimal. iShares U.S. Real Estate ETF, for example, tracks the investment results of the index at an expense ratio of 43 basis points. After expense fees, a $10,000 investment in 16 years ago would now be worth $45,000. About 10 percent annual compounding return. But it is not a free lunch.     

Fees matter. “When stated as a percentage of assets, average fees do look low,” notes Charles Ellis of the Whitehead Institute. “But the investors already own those assets, so investment management fees should really be based on what investors are getting in the returns manager produce.” In the past 10 and 15 years, the passive management fee equaled 5 and 8 percent, respectively. Viewed in this light, the fee is identical to commercial real estate property management fee.  

Yet the index fund managers do not manage real estate. Instead, they track the market capitalization value of the REITs companies over time. Their academic background is in studying chemical engineering, computer science and economics. And their time is spent on the construction and maintenance of the index.

It is a lot of work. The index is reviewed often to account for corporate events such as mergers, takeovers and bankruptcies. If a company is sold to private investors, it is removed from the index. The index is also reconstituted annually in September. The process includes a review of all stocks in their respective markets to determine eligibility according to existing criteria. And because the index is weighted by float-adjusted market capitalization, if market capitalization increases, a company weight in the index decreases. 

In short, seeking income through dividend distribution and obtaining exposure to U.S real estate companies often motivates investors to purchase a passive real estate index that tracks the valuation of REITs companies. But it is questionable how sensible it is to invest at a 30 times price to earnings ratio. And an expense management of 43 basis points is less innocent than perceived at first glance. And since your investment real estate manager’s skill lies in index construction and econometrics models development, perhaps it is time to remember that stock markets are indifferent to mathematical genius. Sir Isaac Newton said it best: “I can calculate the motion of heavently bodies, but not the madness of people.”