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A new designation under the Global Industry Classification Standard (GICS) treats public real estate companies and real estate investment trusts (REITs) as distinct from the Financials sector, which also includes Banks, Diversified Financials and Insurance. The change is good news for the industry, both as a recognition of growth over the past quarter century, and as a harbinger of investment dollars that will likely flow into the sector as investors diversify portfolios by adding or increasing real estate exposure. Tom McNearney, Transwestern’s chief investment officer, discusses the change and what it means for publicly traded real estate companies, investors and their advisors.

THE WHAT, WHEN AND WHY OF GICS SECTOR 11

S&P Dow Jones Indices and MSCI Inc., which have jointly maintained the GICS since its development in 1999, historically have included REITs and public real estate companies as a subset of the Financials sector. The index committee reviews the standard annually to keep it relevant to trading, however, and trading in real estate equities and REITs has mushroomed in recent years. So in March 2015, the committee announced that real estate would get its own sector at the end of August 2016.

When the markets open on Sept. 1, the standard will include an added, 11th sector encompassing equity REITs and real estate management and development companies, under the code 60, allowing for more seamless global comparisons for this type of investment. The standard also is renaming the Real Estate Investment Trusts Industry as Equity Real Estate Investment Trusts, which excludes mortgage REITs. The latter remains in the Financials sector under a newly created sub-industry.

A FUNDAMENTAL DIFFERENCE

Modern portfolio theory tells us that building a portfolio of assets generating returns that are uncorrelated with each other can reduce risk and increase the overall return. Commercial real estate returns, based on property fundamentals and performance rather than on the fundamentals driving banks and insurance companies, bear a low correlation to stocks and bonds. This low correlation appeals to portfolio investors because it offers a diversifying element as well as enhancing returns. Therefore real estate merits inclusion in a portfolio, not as an alternative investment, but as a core asset to mitigate risk and increase overall returns.

REITs already provide great investment value to investors large and small. Since the Great Recession, REIT values have increased by double the performance of the S&P 500. REITs are also a good source of current income, providing a dividend yield of 4.0 percent, approximately double that of the S&P 500. The growing popularity of investing in real estate through equities, and the proliferation of publicly traded REITs, create plenty of options for placing capital in the sector. We believe REIT volatility was in part due to their inclusion with financial companies, so their removal into a new investment class should reduce price volatility and expand their portfolio-enhancing powers.

"Commercial real estate returns, based in property fundamentals and performance rather than on the fundamentals driving banks and insurance companies, bear a low correlation to stocks and bonds."

RECLASSIFICATION REFLECTS HEALTHY GROWTH

REITs were a small investment class when the GICS debuted in 1999, and it wasn’t until 2001 that the S&P Dow Jones Indices allowed their inclusion, along with other real estate companies, in the S&P 500 as a subset of Financials. Since then the total capitalization of REITs has grown tremendously, from about $5 billion at the beginning of the 21st century to almost $900 billion today. AEW estimates that Sector 11 will encompass approximately 2,600 companies, including more than 700 equity REITs and almost 1,900 real estate management or development companies. The commercial real estate industry has matured in that sense and is now large enough to merit index tracking as its own sector. In fact, it will be the ninth largest out of the 11 GICS categories and similar in size to the Utilities sector.





REAL ESTATE HAS EXPANDED ROLE IN PORTFOLIO STRATEGIES

The growing popularity of real estate and REITs among investors, and suggestions that real estate should stand on its own, ultimately swayed index publishers to reclassify the property sector under the GICS. In an article published June 22, David Blitzer, chairman of the index committee, observes that the real estate share of the S&P 500’s market value has grown steadily in relation to non-real-estate financials since 2001. According to Blitzer, it was comments from investors, real estate industry participants and other sources that spurred the decision to break out real estate from the Financials sector. On Sept. 1, REITs will have a 3 percent weighting of the S&P 500 and Financials will drop to 12.5 percent of the index.

Carving out real estate from the Financials sector is not expected to affect commercial property values or share prices appreciably. What will change is the way investment managers view the sector – and weight it in their portfolios. Additionally, we expect that public real estate will be freed from the volatility of the Financials sector and perhaps behave more like private real estate, with a lower correlation to stocks and bonds.

Just as REITs enabled a wider field of investors to acquire exposure to real estate, the 11th sector will generate increased analyst attention, discussion and news coverage. That will put real estate on the radar screen for a larger audience of portfolio managers, many of whom may not have considered the industry’s importance until now.

Before the GICS change, and perhaps due to REITs’ inclusion with more-volatile financial firms, many total-return funds lacked a REIT weighting commensurate with their market capitalization. That will begin to change after Aug. 31. With real estate commanding an entire sector on the major indices, fund managers will have to adjust those weightings to better reflect market capitalization. Based on current estimates of underweighting, that shift will funnel about $100 billion into the sector.

Tom McNearney

TOM McNEARNEY leads Transwestern’s capital market efforts for development and investment nationwide and directs the execution and expansion of the firm’s principal investment activities. Tom also serves on the firm’s investment committee and board of directors for both Transwestern and Ridge Developoment Company.

+1 972.774.2523
Tom.McNearney@transwestern.com
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