PMC Weekly Review - September 9, 2016

A Macro View – Real Estate is in the House

In November 2014, S&P Dow Jones Indices and MSCI Inc. issued a press release announcing the creation of an 11th sector under the Global Classification Standard (GICS) structure. That sector, Real Estate, was implemented last week—marking the first time the GICS structure has been updated since it was created in 1999. Although the impact of this decision will play out over time, it now is clear that Real Estate Investment Trusts (REITs) have found their own home.

Formerly housed under Financials, the Real Estate sector will include equity REITs (REITs that own physical property), as well as real estate management and development companies. Mortgage REITs (REITs that comprise mortgage-backed securities) will remain within the Financials sector. The most immediate impact of this decision is its effect on various benchmarks widely used by investors. For example, the S&P 500 will include the Real Estate sector in its asset allocation beginning September 16. This will result in a 3.23% weight for Real Estate within the S&P 500 moving forward—which is greater than both Telecommunication Services and Materials. The market weight for Financials, on the other hand, will dip from 15.75% to 12.52%, and will rank below Healthcare as the second-largest sector within the index. The impact on many smaller cap indices—in which REITs make up a greater percentage of publicly-traded companies—is likely to be even more profound.

Asset managers undoubtedly will be forced to rehash how they both view the Real Estate sector and implement REITs in their
portfolios. Historically, many asset managers and investors alike have underweighted REITs, since they were not deliberately carved out within their benchmarks. That is, a benchmark-aware investor could avoid REITs altogether by investing in enough financial stocks to remain sector-neutral. As asset managers who once underweighted real estate in portfolios begin to change their tune, demand for REITS could increase significantly, and potentially be a boon for the sector as a whole.

Whereas the increase in demand seems a foregone conclusion, investors should remain wary. Adding the Real Estate sector to the major indices also makes REITs far more visible than when they were hidden within Financials. Analysts and stock pickers often neglected REITs because they failed to understand that traditional accounting metrics do not accurately reflect REIT valuations. Ratios such as price-to-earnings (P/E) or earnings per share (EPS) do not apply nearly as well as either price-to-funds from operations (FFO) or the capitalization rate for REITS. This increased visibility is likely to result in increased scrutiny as analysts and portfolio managers are forced to become more familiar with REITs. As Wall Street shifts its focus to the new Real Estate sector, the market for REIT shares could become more efficient—materially changing the risk/return dynamics. For a market area that has outperformed the broader equity market dramatically over the early part of the 21st century, it’s anyone’s guess as to what this could mean moving forward.

At the end of the day, we can draw one conclusion for certain: Real estate deserves a seat at the table within in a well-diversified portfolio. The asset class has grown tremendously over the past quarter of a century—breaching the $1 Trillion mark in total equity market capitalization in recent months. S&P and MSCI have responded by offering real estate its own home for the first time.

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