This ETF Has Underperformed the Stock Market For Years -- But I Think That's About to Change

I won't sugar-coat it. Real estate investment trusts, or REITs, have underperformed the overall stock market for some time. Over the past decade, the Vanguard Real Estate ETF (NYSEMKT: VNQ) has delivered annual total returns of just 5.1%, compared with 14.3% for the Vanguard Total Stock Market ETF (NYSEMKT: VTI).

However, this has been largely due to macroeconomic and overall stock market conditions, rather than poor performance by REITs themselves. Specifically, there are three big reasons why real estate has underperformed the overall market so badly:

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• REITs tend to perform best in low-interest rate environments. Over the past decade, we've seen two prolonged periods of rising rates. In fact, even after the recent Federal Reserve rate cuts, the benchmark federal funds rate is 350 basis points higher than it was 10 years ago.
• The COVID-19 pandemic disproportionately impacted commercial real estate. While some property types largely remained unscathed, such as data centers and warehouses, many commercial properties (malls, offices, hotels, etc.) were forced to shut down or operate at reduced capacity for prolonged periods.
• The past decade's stellar returns in the overall stock market have been largely fueled by the rise of mega-cap tech stocks, especially those with an AI focus. The long-term average returns of the stock market are about 10% annually, so not only has real estate performed poorly, but the overall stock market has performed exceptionally well.

Could we be at an inflection point?

To be clear, I'm not saying the AI stocks that have been fueling the market are set to fall, but I do think a lot of future growth is already priced in. Meanwhile, the average REIT trades for just about 14 times funds from operations (FFO-the REIT equivalent of "earnings").

Although interest rates aren't likely to fall sharply, most experts expect them to gradually trend lower over the next few years, which could be a major catalyst for REITs for several reasons. Most obviously, lower rates make it cheaper for REITs to borrow money to grow. Also, a lower-rate environment tends to cause money to flow out of risk-free assets, such as Treasury bonds, and into dividend stocks as investors seek higher yields. Finally (and most importantly), commercial real estate values are rather dependent on the current interest rate environment -- in other words, when rates fall, properties tend to have higher market values.

The bottom line is that now could be an excellent time to invest in REITs. And if you're looking for broad exposure to the real estate sector, the Vanguard Real Estate ETF, which tracks an index of about 150 REITs and has a 2.8% dividend yield, could be a great addition to your portfolio.

Matt Frankel, CFP has positions in Vanguard Real Estate ETF. The Motley Fool has positions in and recommends Vanguard Real Estate ETF and Vanguard Total Stock Market ETF. The Motley Fool has a disclosure policy.