SET Monthly Issue December 2016

| December 6, 2016

The Unintended Consequences Of A Cigar Tax

In 1960, when President Eisenhower signed the Cigar Excise Tax Extension, he set something in motion that went well beyond parejos and figuardos.

Because of Washington’s bizarre legislative mashups, Public Law 86-779 gave people the opportunity to invest in portfolios of income-producing real estate.

Eisenhower’s cigar tax law lit up Real Estate Investment Trusts, better known as REITs.  The first REITs were investments in pools of mortgages.  Federal laws changed again in 1976, which allowed REITs to be set up as corporations.

In 1986, REITs evolved again when investors were handed a tax break bonus.

Six years later, Taubman Center, the shopping mall developer, issued a groundbreaking REIT.  Today, there are more than 200 REITs registered with the SEC.  Most trade on the NYSE.

The REITs cover real estate investments ranging from medical office buildings to rental storage units.

For the past 12 years, Vanguard has offered an ETF that tracks the REIT index.   Because of its proven ability to deliver income, the Vanguard REIT ETF (VNQ) is our recommendation this month.


The Vanguard REIT ETF launched in the fall of 2004.  Through the summer of 2016, the ETF soundly beat the broader market.  It returned 192%, including dividends, versus 89% for the S&P 500.

Here’s how the ETF has been doing…

Vanguard REIT ETF

The recent downturn you see in the chart…

The real estate sector is the market’s black sheep right now.  It’s been the worst performing sector of the S&P 500, with a 7.9% loss since it became its own group in September.

This doesn’t concern us.  We’re happy to find income at a price that’s not in the high rent district.

By law, REITs need to pay out at least 90% of taxable profits as a dividend.  This means that you can expect roughly two-thirds of total returns to come from dividends.

Not bad, except for two things.  A REIT can’t build up a war chest of spare cash for a rainy day.

This caused big trouble in 2008 – 2009 when some real estate developers were hit with loans called in and were forced to sell off stock at bargain basement prices.

The other thing to keep in mind with REITs is the impact of rising interest rates.  It’s not accurate to say that when rates go up, REITs go down, but there’s a relationship.

This relationship varies from one type of real estate asset to another.   Because most people think rising rates are bad for every REIT, there are bargains to be picked up right now.

When interest rates go up, two things happen to REITs.  Because borrowing costs go up, profitability can go down.  The REIT might be held back from acquiring property it wants to add to its portfolio.

The other factor… investors may see REITs as less attractive investments because of the returns they can get from bonds.

Looking back, we can see the relationship between interest rates and REITs in black and white.

In 2014, REITs were up 10.71% and ten-year Treasury yields fell from 3.03% to 2.17%.

What’s been happening lately?


In February, VNQ fell to $71.47.  By late July, it rebounded to $92.45.

We like the current price of $81.11, and we believe that the pricing of the ETF reflects the market’s expectation of more interest rate hikes ahead.

But don’t be surprised by short-term pricing volatility.

Take a look at the chart and you’ll see significant pricing swings over the course of a year.  This, coupled with income, is why The Vanguard REIT ETF is a long-term position.


The ETF has $30 billion in assets.  The expense rate is a low 0.12%.

The ETF tracks the MSCI US REIT Index which is comprised of 148 different REITs.

The top five holdings…

Company Name Sector % Weight
Simon Property Group Inc. Real Estate 7.36%
Public Storage Real Estate 4.03%
Prologis Inc. Real Estate 3.51%
Equinix Inc. Real Estate 3.17%
Welltower Inc. Real Estate 3.13%


Simon Property Group Inc. (SPG)

This REIT is by far the largest position tracked by VNQ, and it has the largest collection of concerns.

The big concern… how will shopping malls and outlet centers do as more retail business takes place online?

The firm invests globally in regional malls, premium outlets, mills, and community/lifestyle centers.

Yield:  3.64%

Public Storage (PSA)

The firm acquires, develops, owns, and operates self-storage facilities in both the U.S. and Europe.  It also markets insurance policies to storage unit renters to cover possible losses along with padlocks and cardboard boxes.

Yield:  3.82%

Prologis Inc. (PLD)

The REIT formerly known as Security Capital invests in industrial distribution and retail properties.

Yield:  3.32% 

Equinix Inc. (EQIX)

This REIT with a tech flavor invests in data centers, operations space, storage space, cabinets, and power source.

Yield:  2.05%

Welltower Inc. (HCN)

The sweet spot for Welltower is senior living and health care properties.  Other holdings include medical office buildings, inpatient and outpatient medical centers, and life science facilities.

Yield:  5.43%


It’s all about income.  Right now, the ten-year Treasury yield is 2.3%.  The VNQ yield is 3.72%.  The year-to-date return is 5.37%.

REITs are not a good place to look for capital appreciation.  We expect the net asset value to remain stable, and the yield to remain strong.

This is a core holding for the long term.  It complements the dividend income delivered by the PowerShares Dividend Achievers and the Vanguard High Dividend Yield ETF.

Trade Alert

Buy: Vanguard REIT ETF (VNQ) up to $82.50

Recent Price:  $81.11

Price Target: $86.00

Stop Loss:  $79.25



Consumer Discretionary XLY +5.33%
Consumer Staples XLP +0.28%
Energy XLE +25.15%
Financials XLF +2.24%
Health Care XLV -5.19%
Industrials XLI +7.72%
Materials XLB +18.39%
Real Estate XLRE -3.57%
Technology XLK +10.06%
Utilities XLU +8.27%



. . . . PowerShares Dividend Achievers ETF $PFM – BUY

The rising tide that lifts all boats has been kind to both our dividend ETFs.  PFM is approaching the buy up to price of $23.00, and may not be a member of our buy list for long.

Current yield is 1.97%.

. . . . First Trust ISE Global Engineering & Construction Index Fund $FLM – BUY

Even though this is narrowly traded, it has been a beneficiary of the post-election surge.  Like our dividend ETFs, it is approaching its buy up to price of $50.00.

Current yield is 1.97%.

. . . . Vanguard High Dividend Yield ETF $VYM – BUY

Solid recent gains, and approaching the buy up to price.  This ETF remains a long-term, core holding.

Current yield is 2.96%.

Buy up to $77.00.  The price target is $82.00.

. . . . iShares MSCI Emerging Markets Minimum Volatility ETF $EEMV – BUY

This ETF is still lagging the broader markets.  We are happy to hold and wait for the inevitable rotation of institutional equity investments into emerging markets.

Buy up to $59.25.  The price target is $76.00.

 . . . . Vanguard Information Technology ETF $VGT – HOLD

Tech took a break while other market sectors raced ahead, but a recent surge has once put VGT over our buy up to price.

Current yield is 1.30%.

The price target is $127.00.

. . . . First Trust ISE-Revere Natural Gas Index Fund $FCG – HOLD

Natural gas prices have soared, and so has the Revere Natural Gas Index ETF.  The market price is now above the buy up to price, so move from buy to hold.

The price target is $37.00.

. . . . PowerShares S&P SmallCap Energy ETF $PSCE – HOLD

The energy sector has been the belle of the ball following OPEC output agreements.  The ETF now trades above its buy price, so move from buy to hold.

. . . . Aberdeen Chile Fund $CH – HOLD

The ETF continues to trade in a narrow range.  We’re happy with our 15% gain and we’re happy to hold.

The price target is $11.00.

. . . . Utilities Select Sector SPD $XLU – HOLD

Month after month, we stick to the same story… continue holding.  This ETF remains a solid defensive, long-term position.

Portfolio Changes

  • This month we’re buying Vanguard REIT ETF (VNQ) up to $82.50.
  • Move PowerShares S&P SmallCap Energy ETF (PSCE) from Buy to Hold.

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