Why New Real Estate Sector Good For Investors

August 30, 2016

Come September, real estate will become its own sector under the Global Industry Classification Standard (GICS).

That will be the first time a new sector is added to GICS since it was created in 1999, and investors who own financials ETFs linked to either an S&P or an MSCI index will see changes to their portfolios. Currently, real estate companies and REITs are part of the financial sector.

We asked ETF strategists whether the upcoming change is good for investors and for portfolio construction. Here’s what they had to say:

Mike Venuto, CIO, New York-based Toroso Investments

REITs should never have been part of financials. They react differently to interest rates than financial service firms and trade at much frothier fundamentals. This contradiction should have been corrected long ago.

Also, from an ETF or passive-ownership point of view, REITs are quite over-owned. On average, 12% of their market cap is held by ETFs, while most equities, including financial services, are less than 5% owned by ETFs.

This may explain why REIT valuations are so high. Removing them from the financial sector should reduce valuation risk.

Furthermore, the tax/pass-through structure of REITs negates many of the inflation benefits of owning real estate. What this change really highlights is the need for a pure real estate ETF.

Benjamin Lavine, CIO, 3D Asset Management, East Hartford, Connecticut

Breaking out REITs from the rest of financials will be helpful for portfolio construction, giving investors more transparency to the kinds of risks reflected within their financial sector holdings.

The dynamics that drive REIT stock performance are somewhat different from that of other financial subindustries such as banks, insurance companies, asset managers, specialty lenders, etc. REITs have both equity- and bondlike characteristics.

Since REITs pay out most of their earnings to shareholders, and that real estate is valued based on capitalization rates (net operating income/sales price), REITs can behave like fixed income. However, REITs also contain both equity and credit risk, which can lead them to perform well during an upcycle (due to the growth component in net operating income—think rising lease rates and occupancy), and poorly during a downturn (many REITs were hurt due to their high debt levels and lower occupancies).

The below chart plots the U.S. national apartment capitalization rate versus 10-year U.S. Treasury yield for the period Jan. 31, 2001 through July 31, 2016. The relationship has gotten a lot tighter post the 2008 financial crisis such that REIT valuation are more highly dependent on Treasury rates, making them effective bond proxies along with utilities and other high-yielding dividend payers.

 

 

In this current environment, if interest rates were to rise, and assuming a steeper yield curve, this would benefit banks and insurers (due to the higher spread and carry) and hurt REITs.

This move will also help the tactical sector rotators because those models will get a much cleaner signal with REITs removed from the rest of financials. This move does not change how we allocate to REITs because our firm has always treated REITs as a distinct subasset class apart from the rest of equities.

 

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