SCHH: Limited Value In Real Estate In This Macro-Environment

Main Thesis & Background

The purpose of this article is to evaluate the Schwab U.S. REIT ETF (NYSEARCA:SCHH) as an investment option at its current market price. This is a broad sector ETF, with a stated goal to track, “the total return of an index composed of U.S. real estate investment trusts classified as equities”.

It has been just over a year since I wrote about SCHH, and at that time I thought Real Estate might be due for a bit of a comeback. Looking at the return since last January, SCHH has managed to deliver a small gain. But that pales in comparison to the broader market and actually under-performs cash. So it is safe to safe my bullishness was not the correct outlook:

Clearly, SCHH (and the broader Real Estate sector) has been a laggard. But it is noteworthy that the sector has seen a bit of a boost along with the rest of the market since Q4 last year. This begs the question – is SCHH still a buy?

Personally, I think my prior buy call being incorrect helps to support why a downgrade here makes sense. While I see some positive attributes for the fund and sector, not enough has changed on a macro-level for me to really get excited about this investment idea in the early stages of 2024. I think under-performance will continue, which is why I am placing a “hold” rating on this ETF going forward, and I will get into the details on why I feel this way below.

Real Estate Loans Are Showing Signs Of Stress

To begin, I want to take an overall view of the commercial Real Estate sector. The fact is this is an area that has been fraught with challenges. Many of these are not “new” – the fallout from the Covid-19 pandemic has changed the way households, companies, and cities operate. This has posed many challenges for those who own commercial properties themselves or who lend based on their value. As more people are working from home, shopping from home, and living further out from urban commercial areas, real estate prices have plunged. This has left investors paying the price, and borrowers debating whether or not to continue to make payments on their obligations (if they even can).

While this has been the case for a while, for a variety of reasons the problems have been brushed under the rug. There was significant federal stimulus support, investors were hoping for a rebound, and a dovish outlook for interest rates (which began a long time ago) was anticipated to be a tailwind for the Real Estate sector. Ultimately, the environment remains challenging as the macro-headwinds remain firmly in place. This has led to buildings being sold at sharp discounts and borrowers going into arrears on their loans. A snapshot of delinquencies shows just how pronounced the challenges are:

It is important to remember that SCHH does not invest directly into CLOs. Rather, SCHH’s portfolio is made up of REITs that trade like equities on the open market. So an uptick in delinquencies is not going to directly impact SCHH’s quality.

But it does have indirect concerns. Weakness in the underlying sector is never a good thing for a Real Estate ETF. Further, the REITs that SCHH does buy could be seeing their valuations drop as a result. This will translate in to a lower price for SCHH by extension, helping to support why I am not bullish on this investment idea while loan quality deteriorates.

What Are Some Positives?

As noted, I am not a straight-line bear on SCHH here. I think the broader sector’s under-performance is concerning, but oftentimes under-performing sectors can become the next leaders. There is always this possibility with Real Estate, and that is especially true if interest rates begin to decline. I personally don’t think that will happen until the second half of 2024 – so I see no need to rush in here. But I could certainly be under-estimating that, and there are other reasons why someone may want to buy-in here. Presenting the bull case is central to providing a balanced review, so I will undertake that now.

For example, SCHH does hold a lot of data center exposure. This is an area that has seen plenty of growth and large deals over the past few years. With the “AI” theme captivating markets, the providers of the physical space to store and manage data could get caught up in some of this hype. That could draw investors into some of the names in this sub-sector, which include REITs such as Equinix (EQIX) and Digital Realty Trust (DLR), and as it happens, these are two of SCHH’s top holdings:

Data center providers continue to be in-demand and this will certainly give a boost to SCHH as a result. Beyond just growing demand, this is a sub-sector of the Real Estate market that is getting more efficient. While other buildings like commercial office space and industrial buildings are struggling in many cases, data centers are cramming more and more power into their square footage.

For example, consider that just a few years ago average power densities were around 8-10/kW per rack. Today, that figure has grown measurably, and is forecasted to continue to keep growing throughout the decade:

This is a key driver to the sub-sectors profitability, and the future does look bright indeed.

But there are challenges as well. If this was such a “screaming buy”, I might overlook some other headwinds for SCHH and buy-in to this fund anyway. But, unfortunately, headwinds exist even for data centers and the REITs that own them.

In particular, the “green” push towards making the power grid more sustainable and environmentally friendly is going to cost these centers money. They will need to do their part to meet renewable energy goals – which could get more aggressive over time depending on the political environment. While these enhancements or modifications may end up becoming a net-gain over time to profitability, the upfront cost should not be ignored, especially as borrowing costs remain elevated. This poses a unique risk to this sub-sector that other REITs aren’t facing right now.

I Suggest Getting More Creative Than A Passive ETF

As my followers know, I generally devote a good portion of my writing (and my personal holdings) to passive ETFs. I think sector timing and diversification are key to my individual success, and leverage low-cost ETFs in a big way. For this reason, SCHH is a natural place for me to look when I consider Real Estate. But the fact is that this sector faces many headwinds right now that suggest getting more creative is probably the best play.

What I mean is, rather than owning a diversified REIT like SCHH (which I normally favor for the diversification), consider going into the sub-sectors like data centers individually. Or, just buy a handful of REITs directly and stay balanced that way. In this fashion, you can avoid some of the junk or lower-performing REITs and just focus on those that are best-in-class, or at least avoid the sub-sectors with a more cloudy outlook.

The rationale for this is straightforward. REITs are not a one-stop shop. A “REIT” can mean a lot of things – different types of companies, catalysts, regulatory environments, and/or geographic exposure, among other factors. In this light, it probably shouldn’t surprise readers to know that net operating growth for “real estate” has varied widely depending on the sub-sector:

As you can see, some sub-sectors are on the upswing, while others are not. This is relevant because a sector fund like SCHH is going to own all these REITs – the good and the bad, the out-performing and the under-performing. With a sector seeing some divergence, getting outside of the passive investment realm could be the right call depending on one’s individual circumstances.

Beyond just sector investing, it wouldn’t hurt to look outside US borders either. If we look at the top ten markets for rent growth in 2023, we see a host of international territories:

The overall conclusion I have here is to get more active and specialized with REIT exposure than a fund like SCHH is going to offer. Rent growth divergence, both in terms of locale and sub-sector warrants it.

Dividend Not High Enough

Shifting back to SCHH, consider that despite the share price not offering much in the way of return, the dividend yield is still only moderately attractive. While a yield over 3% used to be good in the zero-rate era, that isn’t the case anymore in my view:

This is not “bad” on the surface, but it highlights a point I made at the onset of this review. One could “invest” in cash at 4-5% in this environment through savings accounts and CD’s. So, from a purely income perspective, SCHH falls short. One would have to rely on share price appreciation and the dividend yield to beat out cash. As we saw from the return since 2023 (my prior article) that hasn’t been the case.

That is not to say SCHH could not push higher in 2024. I don’t have a crystal ball and Real Estate as a whole could certainly come back in favor. But I’m not banking on it, and I would look for individual REITs that yield more if I wanted a pure income play. SCHH just isn’t going to get it at 3.4%.

Final Thoughts

SCHH has been a disappointment and I wouldn’t be surprised if that continues. Investors in REITs need to fully appreciate and recognize the unique challenges facing this sector and why a swift turnaround isn’t likely. The remote work and shopping trends that accelerated post-pandemic are slow to adjust back to “normal” here in the US. Perhaps a new normal has emerged, and that is going to continue put pressure on the value of commercial properties, especially for office space and retail venues:

While quality office space in prime locations will command top dollar going forward, the average REIT doesn’t just own prime space. This dynamic makes passive investing challenging in this macro-climate.

For me, I think the data center theme remains one that investors want to capitalize on. Further, I think apartment REITs still have some value. While borrowing costs are hurting returns and supply has risen, the continued price appreciation of single-family homes will simultaneously support higher rent prices – primarily in growing regions like the Southwest and Southeast:

Because of this, I reiterate that buying individual REITs or more actively managed Real Estate investments is probably the right move in 2024. In that vein, I don’t see a compelling case to buy SCHH, and believe “hold” is the right rating and has been well supported in this review.