<!-- Swiftype Variables -->

Investing

Index breakouts of real estate securities called good news for investors

Michael Underhill
Michael Underhill said a ‘structured tsunami into REITs’ could have a positive impact for institutional investors as valuations climb.

The decision by two major stock index providers to break out real estate securities into a separate sector could, in the long term, benefit investors by dampening real estate stock volatility and pushing up valuations.

Real estate now is lumped in with financial companies such as banks and insurance companies in the Global Industry Classification Standard, which forms the basis of S&P Dow Jones Indices and MSCI Inc. stock indexes.

Starting Aug. 31, the two index providers plan to split real estate from financial stocks, which industry insiders expect over time to result in more capital flowing into real estate securities and less volatility for those securities.

The change will affect investment strategies based on MSCI and S&P Dow Jones indexes, leading managers that offer such strategies to change their holdings. New investment products might also be created based on the changes.

(The London Stock Exchange Group, which offers the FTSE Russell indexes, uses its own classification system called The Industry Classification Benchmark, which already separates real estate from financial service companies, said Mark Benhard, spokesman, in an e-mail.)

Broad equity index funds based on MSCI and S&P Dow Jones indexes, which represent more than $5 trillion in invested assets, are underweight real estate investment trusts — 2.3% compared with the 4.4% index weighting, according to calculations by executives at real asset manager Capital Innovations LLC, Pewaukee, Wis.

Some $100 billion more could flow into REITs should the change push managers to bring their investments up to the market weighting, said Michael D. Underhill, founder and chief investment officer of Capital Innovations. “It will be a structural tsunami into REITs,” he said.

And that could have a positive impact on institutional investors' portfolios.

“More money will be driven into REITs ... and so valuations will continue to climb and there will be continued outperformance in the REIT space,” Mr. Underhill explained.

Short-term volatility

Nobody expects $100 billion to move into REITs on Sept. 1. Indeed, some in the real estate securities industry expect a degree of increased volatility in the short term as equity managers sell real estate securities to readjust existing portfolios.

But the sell-off could be relatively small. According to an analysis by the National Association of Real Estate Investment Trusts, a Washington-based trade group, investors apparently do not typically invest in REITs and real estate companies through funds focused on the financials sector of the GICS.

Some $30.2 billion was invested in the combined equity holdings of 31 funds focused on the financials sector other than real estate as of June 30, 2014, according to the most current analysis available from NAREIT. About $4.2 billion of that total was invested in REITs.

However, real estate securities managers have long maintained that generalist equity managers are underweight real estate. The addition of a separate category, they said, is expected to make real estate securities harder for equity managers to ignore.

There should be increased demand for real estate securities based on a recognition that real estate is fundamentally different from other financial stocks, they said.

“The traditional manager that has been benchmarked to an index that has financials in it has been underweight REITs,” said Thomas Bohjalian, executive vice president in the New York office of real asset manager Cohen & Steers Capital Management (CNS) Inc. (CNS)

If broad equity managers bring real estate securities to market weighting, Mr. Bohjalian also estimates there would be $100 billion more capital invested in REITs.

What's more, the change could in the long term dampen overall volatility of REITs, he said. Volatility is a REIT feature that has long caused some investors to shy from the sector, he said.

“Over the long term it (the GICS change) will create a broader ownership of REITs, which should translate to greater liquidity, which typically has a dampening effect on shorter-term volatility,” Mr. Bohjalian said.

“I think (creating a separate category is) a good thing. We'll see modest tailwinds and over time, we will see greater benefits to the change in the GICS code,” Mr. Bohjalian said.

Hard to ignore

Real estate securities also will be harder for equity managers to ignore.

“REITs will be the ninth-largest out of 11 categories,” said Peter Rogers, Chicago-based senior investment consultant in the manager research group of Willis Towers Watson PLC. “It'll be larger than the telecommunications services and utilities sector.”

Real estate securities will represent 5% of the total equity market capitalization, he said; equity money managers “will have to take a view of why they are underweighting the sector.”

What's more, REITs produce higher dividend yield than financial stocks, Mr. Rogers said.

Separated from financials, the real estate GICs sector would have an average dividend yield of 2.8% compared with the financials average dividend yield of 1.9% as of Sept. 30, according to research by real estate manager AEW Capital Management LP, Boston. This would make real estate the fourth-highest yielding of the GICS sectors, the research paper noted.

The change also will make real estate securities a greater area of research and analysis for stock analysts, which could lead to an increase in capital invested in real estate securities.

“If you are doing research and using the GICS system and you are trying to identify industry trends ... you don't have to account separately for real estate (now) because it is not seen. ... It's buried in the financial sector,” said Michael R. Grupe, executive vice president, research and investor outreach at NAREIT in Washington.

The addition of a real estate sector elevates real estate securities in asset allocation deliberations.

“It can only help increase the flow of capital,” Mr. Grupe said. “But it may take some time for all of that to play out.”

At the same time, increased attention by generalist equity managers could bump up competition for specialist real estate managers, Willis Towers Watson's Mr. Rogers said.

On the one hand, increased capital flows into REITs could heighten volatility and create opportunity for active managers in specialist groups that know the real estate sector, he said.

On the other, it could make the real estate securities market more efficient, with increased scrutiny and analysis. “We may see an erosion of alpha as more market participants start looking at and understanding REITs,” Mr. Rogers said. n

This article originally appeared in the January 25, 2016 print issue as, "Index breakouts of real estate securities called good news for investors".