Why New Real Estate Sector Good For Investors

ETF strategists weigh in on the upcoming debut of real estate as a GICS sector.

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.

Clayton Fresk, Portfolio Manager, Georgia-based Stadion Money Management

The splitting off of REITs from financials will ultimately prove helpful to investors. REITs have different characteristics than the other industry groups that roll up under the soon-to-be-former financials sector (banks, insurance and diversified financials). One of these includes correlation to interest rates. REITs have experienced a lower correlation to rates comparatively, whereas REITs outperform when rates are declining, and vice versa.

Additionally, REITs have a dividend payout that more closely resembles other stand-alone sectors in telecoms and utilities. Using data since the beginning of the GICS Level 2 Real Estate classification in October 2001, these three industry groups are the only ones that have generated dividends in excess of 4% annualized (using the difference in price and total return on the respective S&P 500 Level 2 indices).

Furthermore, this payout did not come with increased correlation to these industry groups (0.34 to telecom and 0.44 to utilities). So for investors looking to gain access to a higher-paying sector while still maintaining a low correlation, REITS could prove beneficial.

One con of this move is that it will make historical performance of the financials sectors less reliable when making future allocation decisions. Since the aforementioned 2001 date, REITs have a nearly 6% price return, while the other three industry groups were either negative or just slightly above zero. So removing this nearly 20% of the “old” financial sector based on today’s weighting will have a sizable effect on the performance of the old and new financial sector.

However, this problem could be mitigated with the publishing of new indices that retroactively account for a financials ex-REIT sector. Another potential con to this move is the “forced” re-examining of an existing sector allocation strategy.

Investors must now choose whether to include REITs in an existing strategy, whereas they may have been automatically included before in a financial allocation. For those who choose to include them, it will take a retooling of the existing strategy, which may or may not cause a significant change in the characteristics of the strategy.

For those who choose to exclude, which may be based on a number of factors (the ultimate size of the new REIT sector which is relatively small, logistical issues, etc.), the investor may not receive a true exposure to a broad sector allocation strategy since REITs would be excluded.

Contact Cinthia Murphy at [email protected]