Growing Pains For New Real Estate Sector

The real estate sector just celebrated its one-year anniversary this month. A little over a year ago―on Sept. 1, 2016―real estate became its own sector after S&P Dow Jones Indices and MSCI decreed the group would split off from financials under the Global Industry Classification Standard (GICS).

The move was historic, creating the first new sector since the inception of GICS in 1999. It was a coming-of-age story for real estate, which, according to NAREIT, has grown from a total market capitalization of $9 billion to $1 trillion over the past 25 years.

The real estate sector is predominantly made up of equity real estate investment trusts (REITs), which develop, own and operate real estate, generating income for investors through rents and price appreciation.

Real Estate Lagging

As impressive as real estate's rise to prominence has been, it's ironic that in the period since becoming a stand-alone sector, the group has fared rather poorly.

Since the Financial Select Sector SPDR Fund (XLF) spun off the Real Estate Select Sector SPDR Fund (XLRE), the latter is up 5.9%, while the former is up 33.8%. For comparison, the SPDR S&P 500 ETF Trust (SPY) is up 19.5% in the same time frame.

XLRE, XLF, SPY Returns Since 9/16/2016

"Last year probably wasn't the best time to have the GICS party," said Alexander Goldfarb, senior REIT analyst at Sandler O'Neill.

There was too much emphasis on all the inflows that were theoretically anticipated to come in from asset managers increasing their exposure to real estate, he explains.

"Those numbers ranged anywhere from $30 billion to $100 billion of buying. That didn't materialize in the way people had hoped," Goldfarb said.

Reasons For Underperformance

According to Goldfarb, there are several reasons investors haven't been enthusiastic about owning the real estate sector in the past year.

"First, there was a view that rates would start going up, so why would you want to own an interest-rate-sensitive sector, especially in the late stages of the recovery?" he said.

"Then, you had the election, and suddenly no one wanted 'safe' REITs; they wanted something with a bit of go-go juice. So they went to the banks and other financials on the view that there was going to be a huge amount of regulatory relief," Goldfarb added.

"Fast-forward to today and you have increased concern about retail,” he noted. “Shopping centers and malls are under pressure because everyone thinks they’ll all close down, and everyone’s just going to sit at home on their couch and order from Amazon."

Retail Concerns Overblown

Goldfarb believes most of the concerns about REITs have been overblown.

"When you look at the companies, they're still growing earnings, they're still growing dividends, they're getting very attractive rates of financing, and almost all have reduced leverage this cycle," he said.

The fears about retail in particular have been exaggerated, in his view. "They're facing some struggles, but they've been maintaining 95% occupancy," he pointed out.

That's a view shared by Haendel St. Juste, senior REIT analyst for Mizuho Securities USA.

Expectations about doom and gloom for retail REITs are "a bit extreme," he said, while noting that he understands why investors are cautious given the uncertainty surrounding the group.

Long In The Tooth

St. Juste says that investors shouldn't abandon the real estate sector, but concedes the cycle is getting long in the tooth.

That's the exact same phrase used by Roy Shepard, senior REIT analyst for Edward Jones, to describe the sector.

"Whether it’s supply or demand, most industries in the REIT space are experiencing some level of moderating cash-flow growth as we are later in the cycle, and the low-hanging fruit of easy occupancy gains (now near peak occupancy levels) and rising property prices have been harvested coming out of the financial crisis in 2009," Shepard said.

Shepard rates the sector as “neutral,” arguing that below-average valuations for the group already reflect the slowdown in cash flows. Goldfarb also rates the sector as neutral, while St. Juste is “constructive, but selective” on REITs.

Financials Surge, Then Cool

As real estate stocks have struggled over the past year, the group they were once a part of has found its mojo. The financial sector was expected to struggle after losing one of its star components, but instead took off. Real estate accounted for 20% of financials before the GICS changes went into effect.

Led by banks, financial ETFs like XLF and the Vanguard Financials ETF (VFH) have leapt more than 30% in the past year.

Most of those gains came in the weeks immediately following the presidential election. XLF and VFH each rose nearly 20% between Nov. 3 and the end of 2016, outpacing SPY's 7.7% gain and XLRE's 5.3% gain.

Since then, the ascent has slowed. XLF is up 10% so far in 2017, compared with a gain of 13.4% for SPY and 8% for XLRE.

Environment Of Hope

"Banks were hit pretty hard last year because of fears about credit related to low energy prices," said Marty Mosby, director of bank and equity strategy at Vining Sparks. "Then after the election, you had hopes of deregulation and the possibility that the economy could pick up."

"All of a sudden you went from a negative perspective to a positive perspective," which led to the sharp spike higher in financial ETFs, he said.

However, since the inauguration in January, "you've had one policy disappointment after the other, and the market has taken the optionality out of the banks," Mosby noted. That's taken a bit of the wind out of financials' sails.

That said, Mosby sees the financial sector outperforming the S&P 500 going forward.

"Banks are back to a fair valuation, and as you look forward, there are still positive catalysts out there such as deregulation, low credit costs and slowly rising interest rates," he said.

Contact Sumit Roy at [email protected]