From the beginning of this month, real estate has been separated from financials and given its own Global Industry Classification Standard (GICS) sector category – significantly raising the profile of an often misunderstood and under-represented asset class.
This change should have a far-reaching impact, as nearly everyone in the investment community uses GICS as a framework for portfolio planning and analysis. As active investors in real estate securities for the past 30 years, we are particularly excited about what this development means for investors and the future of the industry.
We believe the decision to elevate real estate in equity indexes is a testament to the increasing role of real estate in global equity markets. As of March 2016, there were 323 companies in the FTSE EPRA/NAREIT Developed Real Estate Index, representing a market capitalisation of $1.5trn. Real estate makes up 3.3% of the MSCI World Index and 2.7% of the S&P 500 Index. In the US, real estate makes up about a fifth of the GICS financials sector, which accounts for 15% of the S&P 500. If the new real estate sector were split out today, it would consist of 27 stocks, with a market cap of $524bn. This is about the same size as the utilities, materials and telecom services sectors.
We see three areas in which REITs are likely to benefit from the change of address, both in the short and long term: increased demand, reduced volatility and potential effects on investor allocations.
Despite the importance of real estate to the economy, investors have generally shied away from REITs and other real estate stocks. With the new classification, real estate will likely see a significant lift in its profile.
The appeal of real estate stocks is generally based on a record of strong total returns, low correlations with broad equities and bonds and high dividend yields. As of year-end 2015, real estate companies in the S&P 500 had an average dividend yield of 3.2%. On a standalone basis, this would make real estate the fourth highest-yielding sector in the S&P 500 after telecom services, utilities and energy.
The creation of a new real estate sector should shed light on the fact generalist equity investors are significantly underweight real estate, especially in value oriented strategies.
According to JPMorgan Research*, long-only equity funds in the US – representing $5trn in assets – have a 2.1% underweight in real estate on average. This implies potential inflows of more than $100bn into REITs if managers were to bring their real estate allocations in line with their benchmarks.
We do not expect generalists to suddenly change decades of learned behaviour. However, with the added transparency in sector performance, investors may want to consider the potential consequences of being underweight an asset class that has outperformed the S&P 500 over the trailing 10, 20 and 30-year periods, as well as in seven of the past 10 calendar years. We expect investors will gradually seek to increase allocations to real estate, which could be a significant tailwind for the asset class.
Broader ownership of real estate stocks should lead to greater liquidity, in our view. When you have better price discovery as a result of greater liquidity, this tends to reduce volatility, potentially improving the risk side of the risk-return relationship.
In addition, the financials sector has historically been among the most volatile sectors in the S&P 500. Over time, the separation of real estate from the financials sector may reduce trading linkages between REITs and other financial companies such as banks and insurance companies, thereby removing a potential source of volatility.
Impact on real estate allocations
From an asset allocation perspective, it is important to distinguish between the real estate weighting in an index fund or active stock portfolio and an investor’s overall target allocation. Generalist equity managers could move to a market-neutral weight of 4.4% – the average of all US mutual fund benchmarks – and real estate would still represent only a small portion of an investor’s overall portfolio.
By contrast, many institutional investors target a sizeable allocation to alternatives, including real estate. For example, investors with 50% in equities may have only about 2% of an overall portfolio in real estate. To achieve a 10% total allocation, there would be a need to invest an additional 8% in a dedicated real estate portfolio.
Given the 35-year bull market in bonds and expectations of further rate decisions by the Federal Reserve, investors will likely continue to look for assets providing the potential for attractive, growing income and capital appreciation. We believe the search for income alternatives will continue to drive interest in listed real estate allocations, which will only be magnified as real estate takes on a higher profile.
* At December 10, 2015. Source: JPMorgan Research. Calculated based on all 1940-Act mutual funds classified by Morningstar as Core, Growth and Value across Large Cap, Mid Cap and Small Cap equity, representing $5 trillion in total assets.
Thomas Bohjalian is a portfolio manager at Cohen & Steers