This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Deepika Sharma, managing director of investments and portfolio manager at Astor Investment Management.
Equity REITs are now a separate sector since Sept. 1, and most funds that use S&P indexes as benchmarks have yet to fully implement the change. But once the transition is all said and done, this will affect investors who hold REITs or financials in their portfolios in various ways.
At Astor, we see several trends taking shape in the REITs market, all of which should impact how they will perform going forward. Here are some of our key thoughts:
- We should see increased demand for REITs in the next three to five years.
Most U.S. equity funds are still significantly underweight real estate, especially in value strategies. Based on a December 2015 J.P. Morgan report, there is pent-up demand of $100 billion for real estate funds, as long-only mutual funds have an average real estate underweight of 2.1%. Plus, new tax incentives for foreign investors in U.S. REITS may drive up demand.
Similarly, EPRA, which promotes the European-listed real estate industry, estimates that the classification will attract institutional investors who don’t currently invest in listed real estate because of volatility in the combined financials funds. This could divert €75 billion of capital to the European REITs market.
Some of this demand is already apparent in investor flows. According to Lipper fund flows data, investors have allocated to real estate in droves since 2011, bringing real estate fund flows to $9 billion since then, the third-highest after health care ($11 billion) and energy ($10 billion). But the under-allocation in institutional funds won’t correct overnight, and we expect that other factors such as the REITs market cycle and the impact of the Fed hike will play a bigger role in investors’ allocation decisions.
- The REITs market cycle is tied to GDP growth.
A high dividend yield and robust returns this year (+14% year-to-date as of Aug. 31) put REITs in the spotlight as an attractive opportunity for “search for yield” trades. Investors are drawn to REITs’ improved balance sheets, stronger liquidity and favorable financing options.
In addition, the REITs market cycle is closely tied to GDP growth, as an improving economy implies rent growth, lower spreads and higher loan to value amounts. Due to sluggish growth, REITs’ overuse of bank debt to refinance has led to higher draws on revolving credit available, and reliance on unsecured term loans. This lack of excess capacity may hinder their capacity to ride out potential market volatility.
- The impact of rate hike expectations on REITs
Historically, REITs have underperformed at the early stages of a monetary tightening, but gradually outperformed when higher interest rates are accompanied by a growing economy. In effect, uncertainty about the Fed’s timing is not good for REITs, especially if investors are worried about the effect on the economy.
This is why REITs were sensitive to the volatility in the 10-year U.S. Treasury yield last year and during the “taper tantrum.” Conversely, continued global easing and negative rates in some countries have helped lift demand for U.S. REITs.
The largest REIT ETF, the Vanguard Real Estate Fund (VNQ), was left unchanged following the Aug. 31 reclassification, even though it doesn’t fully track the new real sector. The fund underweights to specialized REITs as well as real estate management and development companies, which are a combined 15.5% of the new sector.