ETF Model Portfolios: The Rental Property Replacement

The ETFs We're Going to Use

For this model portfolio, I'm starting with a 60% allocation to the iShares Residential and Multisector Real Estate ETF (REZ), which tracks the FTSE Nareit All Residential Capped Index. Despite its name, REZ isn't a pure-play residential real estate fund.

Multifamily residential REITs account for just 21.17% of the portfolio, while single-family residential REITs represent another 12.83%. Healthcare REITs make up just under half of its assets, with approximately 16% allocated to self-storage. There's a practical reason for this.

The publicly traded residential REIT universe is relatively small, particularly when compared with sectors such as industrial or retail real estate. Restricting an ETF exclusively to apartment and single-family rental operators would leave relatively few companies to choose from, making it difficult to maintain adequate diversification.

REZ addresses this by expanding its mandate to adjacent property types. Its 36 holdings therefore provide a broader interpretation of residential and demographic-driven real estate, although the healthcare allocation introduces exposure to businesses with very different economic drivers.

For our purposes, I think that's sufficient as a starting point. REZ charges a 0.48% expense ratio and offers a 30-day SEC yield of approximately 2.5%, providing some income alongside exposure to residential property ownership.

Next, I want to temper the portfolio's overall risk with a 20% allocation to the iShares MBS ETF

. MBB invests in agency mortgage-backed securities (MBS), which are bonds backed by pools of residential mortgages. Rather than owning rental properties directly, investors receive exposure to the interest and principal payments generated by homeowners paying down their mortgages.

The fund primarily holds securities issued or guaranteed by Ginnie Mae, Fannie Mae and Freddie Mac. These agency MBS carry high credit quality, with the portfolio's average credit rating around AA, although the precise nature of the government backing differs among issuers.

MBB is also exceptionally affordable, charging an expense ratio of just 0.04%. Its 30-day SEC yield of approximately 4.4% provides considerably more income than REZ, making it useful for balancing the portfolio's relatively modest equity distributions.

However, mortgage-backed securities still carry interest rate and prepayment risk. Falling rates can encourage homeowners to refinance, returning principal to investors sooner than expected, while rising rates can extend the effective life of the underlying mortgages.

That leaves 20% of the portfolio unallocated. I'm splitting it evenly between two higher-risk exposures, each serving a different purpose. For capital appreciation potential, I'm assigning 10% to the iShares U.S. Home Construction ETF

.

ITB tracks the Dow Jones U.S. Select Home Construction Index, providing exposure to major publicly traded homebuilders alongside businesses supplying the residential construction industry. This gives the portfolio exposure to the development side of the housing market, complementing REZ's focus on existing real estate and MBB's exposure to mortgage financing.

Its leading holdings include all five of the major U.S. homebuilders: D.R. Horton, PulteGroup, Lennar, NVR and Toll Brothers. It also owns home improvement retailers such as Home Depot and Lowe's, along with building products suppliers including Sherwin-Williams.

ITB charges a 0.37% expense ratio, but its income contribution is relatively modest, with a 30-day SEC yield of approximately 0.94%. Instead, the attraction is its potential for capital appreciation. With a three-year equity beta of 1.39, ITB has historically exhibited substantially greater sensitivity to broad equity market movements. That could work in its favor during a housing recovery, although it also means potentially larger losses when mortgage rates rise or homebuyer demand weakens.

Finally, I'm allocating the remaining 10% to the iShares Mortgage Real Estate ETF

, this time prioritizing income over capital appreciation. REM tracks an index of mortgage REITs, which are fundamentally different businesses from the property-owning REITs found in REZ.

Mortgage REITs are better understood as specialized finance companies. Rather than primarily collecting rent from tenants, they invest in mortgages, mortgage-backed securities and other real estate debt instruments. Many finance these investments using borrowed money, attempting to earn a spread between the income generated by their assets and their funding costs.

That leverage can support unusually high distributions, but it also introduces substantial sensitivity to interest rates, credit conditions, financing costs and changes in the value of mortgage assets. REM currently offers a 30-day SEC yield of approximately 12.5% after its 0.48% expense ratio, making it by far the highest-yielding component of this allocation.

One important caveat is that REM isn't exclusively focused on residential mortgages. Its holdings include mortgage REITs with significant commercial real estate exposure, so investors are taking on additional risks beyond the residential housing market. Still, for a relatively small 10% allocation, I think it serves its intended purpose as an income kicker

How the Portfolio Performed

With the allocations established, the portfolio has a weighted-average expense ratio of 0.381% and a weighted-average 30-day SEC yield of approximately 4.16%, based on the latest reported yields for its four constituent ETFs. That works out to approximately $381 in annual fund expenses and $4,160 in annualized yield for every $100,000 invested.

Now, not every ETF model portfolio we construct is going to outperform its benchmark, and this one certainly hasn't. Back tested from 2022 onward, the rental property replacement portfolio has substantially lagged the S&P 500 Total Return Index.

Admittedly, this has been a challenging period for virtually every component of the allocation. Residential REITs have faced higher financing costs and pressure on property valuations, while homebuilders have contended with elevated mortgage rates and deteriorating housing affordability. Meanwhile, agency mortgage-backed securities and mortgage REITs have been affected by rising interest rates, with the latter also facing pressure from funding costs and leverage.

The annual performance figures illustrate these challenges. The portfolio's worst year was 2022, when the combination of high inflation and rising interest rates produced a larger loss than the S&P 500. This is an important qualification to the commonly repeated idea that real estate is an inflation hedge.

Over long periods, property values and rental income may rise alongside the general price level, providing some protection against inflation. In the short term, however, higher inflation can prompt central banks to raise interest rates, increasing financing costs and reducing the present value of future rental income. For publicly traded REITs and mortgage-related investments, those pressures can easily overwhelm any benefit from rising rents or property replacement costs.

The portfolio's maximum drawdowns have also been considerable, despite its 20% allocation to fixed income. MBB's high credit quality provides some protection against default risk, but its duration exposure still makes it vulnerable to rising yields. Meanwhile, the remaining 80% of the portfolio consists of equity securities with considerable sensitivity to the housing cycle.

There's also an important psychological difference between owning this ETF portfolio and holding an actual rental property. Provided a landlord isn't overleveraged, facing negative cash flow or otherwise forced to sell, they can generally continue collecting rent and holding the property through unfavorable market conditions. Its market value may be fluctuating considerably in the background, but there isn't a brokerage screen updating the estimated selling price every second.

With publicly traded ETFs, that volatility is immediately visible. The advantage is that investors can liquidate their holdings relatively quickly without finding a buyer, negotiating a sale or paying real estate transaction costs. The disadvantage is having to tolerate daily market pricing, including potentially rapid declines during periods such as 2022.

Ultimately, I see this portfolio as a convenient, liquid way to obtain diversified exposure to the residential housing ecosystem without the operational responsibilities of being a landlord. It offers multiple sources of income and potential capital appreciation, but investors give up the direct control, property-level leverage decisions and insulation from daily market pricing that come with owning physical real estate.

Please note that this article reflects the author’s personal views and does not represent the opinions of the publication or its affiliates. It is for informational purposes only and does not constitute investment advice. It is essential to seek guidance from a registered financial professional before making any investment decisions.