September marks the time of year when Major League Baseball rosters expand and some hotshot prospects get their chance to move up from the minors to the big leagues. Likewise, property real estate investment trusts (REITs), though hardly rookies, are headed toward their own version of the major league: On 1 September 2016, the widely used Global Industry Classification Standard (GICS) is elevating real estate from a subset of the Financials sector to a newly created Real Estate sector. This sector addition is the first since 1999 (when GICS was established), and the Real Estate sector will represent 5% of global market cap, ranking it as the ninth-largest sector, ahead of telecom services and utilities. Mortgage REITs, which typically manage portfolios of mortgage-backed securities (as opposed to property/equity REITs, which manage portfolios of commercial real estate), are generally viewed more as specialty finance companies and will stay within the Financials sector.
REIT market implications
Total REIT market cap has risen to roughly $1 trillion from less than $10 billion at the start of the modern REIT era 25 years ago. Industry pundits have estimated that an additional $30 billion to $100 billion of fresh capital could enter the property REIT space as a result of the new classification, emanating from generalist portfolios that had historically been underweight REITs bringing their positions toward market-weight levels. However, we point out that some of this technical demand has likely already entered the space over the course of the past year in anticipation of the GICS change, as evidenced by the Dow Jones U.S. Select REIT Total Return Index’s outperformance of the S&P 500 by roughly 500 basis points to date in 2016. Additionally, this year-to-date outperformance may result in some hesitancy among generalist managers to add materially at current valuation levels. Nonetheless, we think the change could further support the sector over the longer term. In addition, by potentially spurring a larger allocation within broader generalist portfolio mandates over time, the new classification could create a stickier and more diversified investor base. And daily volatility and price movements would – at least theoretically – reflect the sector’s specific fundamentals rather than the daily flows of the broader Financials sector.
While we are many years into the current economic cycle, and near-term operating trends have moderated across most REIT sectors as demand/supply imbalances have become more normalized, we think valuations on institutional quality commercial real estate still look fair relative to most other financial asset classes. One metric, for example, is the spread between the unleveraged returns an investor can reasonably expect to achieve on a commercial real estate asset today versus the yield on a basket of investment grade and high yield bonds. Today, this spread of roughly 100 bps is roughly in line with the long-term historical average, providing one indication that commercial real estate values are currently priced in the fair zone. (For additional details on how we value REITs, please read our Featured Solution, “Finding a Real Return With REITs.”) Additionally, in a world of continued macroeconomic uncertainty and a “lower for longer” interest rate framework, REITs may offer stable contractual cash flows backed by higher-quality assets. That said, just as all new major league recruits may not become all-stars, all REITs are not created equal. This is evidenced by the dispersion of returns among the top and bottom quartiles both by sector and by individual company (see chart). So security and sector selection within a risk-adjusted framework will remain paramount.