Real estate will be taken out of the financials sector to become a sector of its own as of September 2016. We expect this change to boost institutional demand for real estate, as investors will become more aware of its unique risk-reward characteristics.
In 1999, MSCI and Standard & Poor’s developed the Global Industry Classification Standard (GICS). GICS is a hierarchical industry classification system consisting of 10 sectors, 24 industry groups, 67 industries and 156 sub-industries. To determine a classificastion, companies are classified quantitatively and qualitatively. Each company is assigned a single GICS classification at sub-industry level according to its principal business activity. Under the GICS methodology, revenues are a key factor in determining the business activity, but earnings and market perception also play a role.
Under the current GICS, Real Estate Investment Trusts (REITs) are an industry group within the Financials sector. However, large disparities between the REIT operating landscape and the rest of the Financials sector, as well as the tremendous growth and popularity of publicly traded real estate as a standalone asset class, have prompted a change. As of September 1, 2016, GICS will recognize Real Estate as its 11th standalone sector, comprising Equity Real Estate Investment Trusts and Real Estate Management & Development companies. The Real Estate Investment Trusts industry will be renamed to Equity Real Estate Investment Trusts (REITs). Currently the Real Estate sector represents 3.6% of the total developed world MSCI index and 3.1% of emerging markets.
The real estate sector will have code 60. As of March 2016, REITs in developed markets represent 74% of the totaL real estate sector and the balance of 24% consists of Real Estate Management & Development companies. In emerging markets this split is 20% / 80%. Here we do expect REITs to become a larger part of the industry as countries like China and India are looking into the benefits of of introducing tax-transparent REIT structures. Currently, the real estate sector in developed markets has 13 sub-industry levels including Mortgage REITs. Given the nature of their actvities however, mortgage REITs will remain a sub-industry within the Financials sector.
In the US, the MSCI and S&P Dow Jones indices will implement the change on September 17, 2016. With 27 S&P 500 constituents (26 equity REITs and one real estate services company) and with a market capitalization of nearly USD 520 billion, this change would make Real Estate the 9th largest S&P 500 sector, ahead of utilities and telecom.
A standalone real estate sector will likely create new institutional demand. Several broker research reports indicate that the US mutual fund industry is underweight the real estate sector, which is currently hidden under the financials sector. These underweigths of approximately 2% can be found acrross investment styles and do not just relate to, for example, large cap funds. Over the last 16 years real estate has outperformed financials 14 times and the S&P 500 13 times. Up until now, the negative performance contribution of being underweight the sector did not materialize expclicitly in reports, but having to report the performance attribution of the real estate sector separately may prompt investors to reduce the risks of being underweight.
An increased awareness of the unique risk-reward characteristics of REITs could also lead to greater performance differences across the sub-segments. Companies in the sub-segments operate different business models and industry fundamentals can differ materially. These differences go beyond mere variations in supply and demand.
In the near term we could see some selling pressure of financial ETFs containing REITs, but the change may also bring new (ETF) investors to the real estate sector. The estimated USD 100 billion underweight position is meaningful, as the total market capitalization of REITs is about USD 800 billion. REITS are not the most liquid to trade and globally more than 50% of the real estate stocks have a market cap below USD 10,000 million.
Besides liquidity there could be other reasons why the sector might not be easily embraced by generalists. REITs typically (have to) pay out a significant proportion of their earnings. Generalists could be more interested in growth companies that retain earnings for new investment opportunities. REITs do not fit this criteria and continually tap equity markets to finance the purchase of new assets. We think this discipline may explain their strong historical performance.
The biggest hurdle might be overcoming the differences in valuation methods between equities and real state. Given their significant asset base, REITs typically do have high depreciation charges. However, these charges are not necessarily cash outflows and hence real estate analysts look at metrics like funds from operations (FFO) that include depreciation charges. Generalists using P/E or P/B valuation methods will find the sector expensive. Differences in professional terms might be another obstacle to overcome. Most generalists are not used to look at net asset values and implied cap rates.
On one metric however, REITs do look interesting from a more generalist perspective and this is dividend yield. Currently US REITs trade around a 4% dividend yield. This spread of 200 bps versus 10-year Treasuries is circa 80 bps above the historical average of 120bps.
Whatever the short-term impact could be from the real estate promotion to the 11th GICS sector, in the longer term we do expect REITs to be an important tool in a portfolio diversification strategy. Having reached a correlation to equities of almost 1 during the financial crisis, the real estate sector’s correlation has now halved. As (US) REITs will be less impacted by financials ETF flows, a lower correlation than the historical average could be a real possibility.
Correlation to bonds however has increased as quantitative easing has pushed a lot of fixed income investors into long-duration equities, such as consumer staples and real estate. Now that we are approaching a post-quantitative easing period, these correlations may decline again. If history is any guide, lower correlations combined with solid returns could put real estate firmly back on the map of any investor.