Growing Pains For New Real Estate Sector

September 21, 2017

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.


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