Once a niche investment, real estate investment trusts (Reits) have seen enormous growth in recent years, and the flow of money into the sector may be about to accelerate.
Earlier this month, global equity indices were reconfigured. Since it was established by MSCI and Standard & Poors in 1999, the Global Industry Classification Standard (GICS) has consisted of 10 sectors. Now there are 11. Real estate, previously classified as part of the financial sector, has been recognised as a standalone sector for the first time.
As S&P index committee chairman David Blitzer said in a June blog post, this is more than a case of "rearranging the place cards on the table"; it is likely to result in increased interest in Reits, quoted companies that own or manage property.
Institutional investors around the world use the GICS system to gauge their asset allocations. The European Public Real Estate Association (EPRA) has estimated the change could drive up to €75 billion into European listed property companies. Currently, approximately half of European institutional property investors do not invest in listed property firms, it says, while the remainder allocate an average of approximately 2.5 per cent.
This reluctance, it suggests, is best explained by concern among institutional investors regarding the volatility of public markets, a concern that may be ameliorated by splitting Reits from the more volatile financial sector.
Underweight
The association promotes the European listed property industry, and sceptics might note that investors wary about exposure to volatile banking shares already have access to exchange-traded funds that focus solely on Reits. Still, others have also argued that the new sectoral changes will catalyse interest in listed property.
Many active fund managers have chosen to stick to conventional stocks with which they are familiar rather than venturing into the world of Reits, which come with their own valuation metrics and tax considerations. According to Goldman Sachs, almost 40 per cent of US large-cap managed funds do not own any Reits, while those that do tend to hold an underweight position. Last year, JPMorgan estimated this underweight position could result in some $100 billion in inflows.
Doubtless, some of that money has already made its way into Reits. Changes to the GICS system were first announced last year, so active managers have had plenty time to rotate into the industry. However, recent analysis from Morningstar suggests managed funds remain more than 50 per cent underweight for Reits.
The creation of a new real estate sector means many active managers, who tend to be wary about owning portfolios that differ significantly from benchmark indices, will come under pressure to justify their lack of exposure.
Becoming the 11th GICS sector gives listed real estate additional prestige and prominence. S&P and MSCI, as Financial Times columnist John Authers noted recently, "have done the Reits industry a big favour".
Growing importance
The move recognises the growing importance of listed property firms in global markets. Although first established in the 1960s, there were no Reits in the S&P 500 as recently as 2001. Today, there are 28 Reits and property management and development companies in the index.
Worth more than $600 billion, their total market capitalisation accounts for approximately 3 per cent of the S&P 500 – more than that of the telecom and materials sectors and comparable to the utilities sector. Reits have increasingly gained traction outside of the US, including in Ireland, where three firms – Green Property Reit, Hibernia Reit and Irish Residential Properties Reit (Ires) – have floated on the stock market since 2013.
For investors, Reits are attractive on a number of levels. Offering low-cost, diversified access to property, they are more liquid than open-ended property funds; whereas several UK property funds froze redemptions during June’s post-Brexit panic, Reit investors were free to sell their shares on the stock exchange.
High dividend yields – in Ireland, Reits must pay out 85 per cent of profits generated from their rental businesses in dividends, with comparably high payouts the norm in international jurisdictions – have proven especially attractive to investors in recent years, given the scarcity of yield on offer in other asset markets.
Long-term returns have been stellar. US-listed equity Reits delivered average annual net returns of almost 12 per cent over the 1998-2014 period, according to a study by Canadian-based CEM Benchmarking, more than all other 11 asset classes analysed. Going back further, the Wilshire Reit Index delivered average annual returns of 12.7 per cent over the 1979-2014 period, according to financial blogger and Ritholtz Wealth Management strategist Ben Carlson. Reits have outperformed the S&P 500 over the trailing 10-, 20- and 30-year periods.
Downsides
On the downside, the oft-repeated idea that Reits resemble a bond with a growth component does not stand up to scrutiny. Both may be income-producing assets, but Reits are closer to stocks in terms of volatility, with Carlson noting that the Wilshire index has suffered annual losses ranging from 17 per cent to 39.2 per cent on four occasions since 1979.
Reits were pummelled during 2008 and lost 20.8 per cent in February 2009. The FTSE Nareit UK index has fallen by 13 per cent in 2016. Reits are more volatile than the overall property market, both because they are more leveraged and because they are tied to equity markets. Nor should investors assume steady, rising dividends; dividends are dictated by operating cash flows and can go down as well as up.
There is also much concern that Reits will suffer when interest rates finally rise. Rising rates increase Reits’ borrowing costs, potentially decrease the value of properties and reduce the attractiveness of high-yielding assets relative to more low-risk alternatives.
The notion Reits must underperform when rates rise is a “misconception”, according to an S&P report earlier this year which noted that Reits have only underperformed the S&P 500 in two of the six major rate-hiking cycles since the 1970s. Returns were especially strong in three of those cycles.
Investors sometimes forget rising rates as also associated with economic growth and inflation, both of which boost income generated from rental properties.
Still, the thirst for yield among global investors has undoubtedly benefited Reits in recent years, indicating they are currently especially sensitive to rate hikes. Market action supports this thesis. When rates briefly spiked in May 2013, following comments from Federal Reserve chairman Ben Bernanke regarding the tapering-back of its quantitative easing programme, Reits quickly plunged by almost 16 per cent. Earlier this month, Reits suffered a one-day sell-off of 3.9 per cent.
Valuations
The craving for yield has resulted in income-producing assets generally becoming much more expensive relative to historical norms. Reits, after being the best-performing asset in five of the last six years and beating the S&P 500 in seven of the last eight years, are no exception in this regard. S&P 500 Reits have soared by over 350 per cent since March 2009, compared to a gain of 220 per cent for the index.
In 2000, renowned value investor Jeremy Grantham called Reits "the great no-brainer of this cycle", noting they yielded 9.1 per cent compared to the S&P 500's 1.1 per cent dividend yield. That 8 per cent yield premium has shrunk dramatically to just 1.1 per cent today. Reits offered a dividend yield of about 8 per cent throughout the 1980s and for much of the 1990s; today, the current dividend yield of the FTSE Nareit Global Reits Index is just 3.67 per cent.
In other words, because today’s yields are so much smaller than the yields of yesteryear, the only way that future investor returns can match past returns is by Reits delivering better-than-average earnings growth or through a continued expansion in valuation multiples.
Caution regarding current yields may not in itself curb what MSCI calls the “irresistible rise of Reits”. It recommends investors combine direct property investment in their home markets with an allocation to global Reits to “accelerate diversification” of their property portfolios. Reits also offer diversification benefits to stock and bond investors, given that they have historically had a low correlation with both asset classes.
Correlations may, of course, increase in coming years; becoming the 11th GICS sector means that ordinary fund managers are more likely to find a place in their portfolios for listed property firms. That sectoral change may juice further gains, but replicating the hot returns of recent decades may prove more challenging for long-term Reit investors.
