The REIT breakout. Real estate stocks are getting their own GICS sector. Key themes:

Transcription

1 Real Estate The REIT breakout Real estate stocks are getting their own GICS sector Key themes: The considerable size of the public REIT market and the sector s distinct nature is driving the change The GICS change and increased awareness of REITs is a positive event, but not to be overestimated Equity manager repositioning and flows into REITs will be gradual and likely less than lofty forecasts from others Healthy fundamentals, durable income streams, and above average yields are bigger tailwinds for the sector At the end of August, real estate stocks are breaking away from financials and getting their own Global Industry Classification Standard (GICS) sector. The event s publicity has brought an increased awareness and focus to Real Estate Investment Trusts (REITs) this year. On balance, the Principal Real Estate Securities team believes the GICS change is a positive tailwind for the REIT market, but is not to be overestimated. Asset flows into REITs should tilt positive, but the impact will be evolutionary and a sizeable and lasting impact at the time of the reclassification is unlikely, while correlations and volatility may not decrease as others suggest. Overall, it s an important recognition of the distinct nature of REITs and their importance in today s marketplace. What s changing with GICS and real estate stocks? Real estate companies that fall within two GICS industry classifications, REITs and Real Estate Management and Development, will be moving out of the GICS Financials sector and promoted into a new 11th GICS sector Real Estate. Mortgage REITs, which do not own real estate but are instead a lender on properties, will remain within the Financials sector. This is a notable event because it is common market practice for general equity managers, index providers, and investors to group stocks and make investment allocations based on these GICS sectors. It s also important to understand that the weight of real estate in general equity benchmarks and the index constituents are not changing; instead, the same real estate stocks in these benchmarks are being shuffled over into a new sector. This change will occur starting after the market close on August 31. MSCI will implement the new classification change at this time, but S&P Dow Jones will wait until their planned quarterly rebalance date of S&P indices on September 16 to implement the change. Russell will not be making changes to their indices as they utilize a different classification system. 1

2 Exhibit 1: Real estate weight in major equity indices 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% Source: FactSet S&P 500 S&P Small Cap 600 MSCI USA S&P Global BMI S&P Global 1200 MSCI World MSCI EAFE MSCI EM MSCI World Mid Cap Why are they now breaking out Real Estate into its own sector? Any REIT manager like us would tell you that REITs are not like other financial stocks such as banks or insurance companies. A REIT owns a real, physical asset that typically provides capital appreciation and a durable and contractual income stream to the owner. Combined with the liquidity of trading on a stock exchange and a track record of attractive total returns, REITs have become a very popular way of investing in commercial real estate. Looking at only U.S. REITs, total equity market capitalizations for the sector have soared to over $1.0 trillion and in July, the average daily dollar trading volume was over $7 billion. The considerable size of the REIT market, a differentiated business model compared to other financial stocks, and real estate s growing importance to the world s equity markets have caused the index makers of S&P Dow Jones and MSCI to make this change. Which funds or strategies are going to be affected by this change? Individual investors, active fund managers, passive fund managers, and ETFs should all take note of the GICS change. Some will be forced to take action while others will be unaffected. An easy way to understand the impact on the REIT market is to separate market participants into two groups buyers and sellers. But first, we can eliminate a couple types of investors and funds that will be unaffected by the change and take no action. Passive equity funds or ETFs that track broad market indices, such as the entire S&P 500 or MSCI World, will not need to buy or sell REITs. The weight of REITs in these funds is not changing, only the sector classification. Dedicated REIT-only sector funds, such as the Real Estate Securities strategies we offer, will not be affected by the GICS classification of REITs in a broad equity index. We invest within and across the entire REIT market and are benchmarked to REIT sector indices. Active general equity fund managers are buyers. More accurately, these managers are potential buyers. It s been well discussed this year that general equity managers are underweight REITs. Some have estimated that the size of the underweight is as much as $100 billion, and it represents a significant source of money that could flow into REIT stocks if these managers neutral-weighted the new Real Estate sector. While we agree with the fact that general equity managers appear to be underweight REITs, we are skeptical inflows from this group will be so large or immediate. An underweight to REITs for these managers is a conscious decision and certain factors, such as growth expectations or relative valuations, 2

3 will have more impact on their portfolio weighting decision than the GICS change. Also, we believe many active managers already look through the GICS sectors when making portfolio allocations and view REITs distinctly different than other financials. Not all do, so for some there will be a learning curve, but at Principal we know first-hand our general equity managers have always been mindful of real estate stocks and don t intend to manage portfolios differently. There could be forced buying by some managers who must adopt a GICS sector-neutral approach or have tight sector-relative active weight tolerances, but we would consider these managers to be a small minority among this potential buyer pool. Financial sector mutual funds or ETFs are sellers. These funds track, actively or passively, the Financials sector of an MSCI or S&P Dow Jones index. This is a relatively small group of funds and real estate stocks are approximately 20% of their holdings. We estimate the group collectively owns roughly $5 billion in real estate stocks and that excludes any separately managed accounts. These funds will need to sell the real estate stocks that are being reclassified into the Real Estate GICS sector. Sizeable funds to note are the Vanguard Financials ETF (ticker: VFH), with approximately $1 billion in real estate stocks. This ETF will rebalance at the end of the month with MSCI, but we expect any market disruption to be short-lived. The largest Financial ETF is XLF, the Financial Select Sector SPDR Fund, with approximately $15.4 billion in AUM and $3 billion in real estate holdings. This ETF will not sell its real estate holdings on the S&P rebalance date of September 16, but instead will spin out its real estate holdings via a special dividend to shareholders into a new separate real estate ETF. This spin-out will give investors the option to sell their real estate exposure and we suspect some will, but probably not all, and it will likely be drawn out over time rather than immediate. Exhibit 2: REITs Regularly Outperform Equities The fairly consistent outperformance of REITs relative to equities over the last 20 years warrants the attention of general equity managers. 40% U.S. REITs 30% 20% 10% 0% -10% -20% -30% -40% MSCI US REIT Index relative to S&P 500 Index -50% Source: FactSet 3

4 What are your views on the implications for the REIT market and your real estate securities strategies? On balance, we believe the GICS change is a positive tailwind for the REIT market, but is not to be overestimated. The increased awareness and focus REITs have received this year from the market and media has been good for the sector. Much has been written about the attractive returns REITs have generated, diversification benefits, and above-average dividend yields. This spotlight has hopefully been a catalyst for many investors to come off the sidelines and invest in REITs today or in the future. While we have a fairly modest view on the size of the flows, it s also reasonable to suspect that repositioning by equity managers will lead to additional inflows into the sector. However, the impact is evolutionary as repositioning has been ongoing throughout the year and investors suspecting a large, sustainable rally in REIT stocks in the coming weeks from GICS-related buying activity may be disappointed. As a standalone sector we expect real estate stock correlations with Financials to fall, but with more trading activity from general equity managers we are inclined to think REIT stocks are likely to see correlations with broader equities stay unchanged or increase modestly, rather than go down. Volatility of REITs may also perform in line with broader equities as equity managers increase their ownership of REITs. Whether we are right or wrong on the direction of volatility and correlations, we believe any impact will likely be modest and REITs will always be a liquid and efficient way to diversify your portfolio with commercial real estate. For our active real estate securities strategies, the GICS change will have no impact on how we manage client portfolios and our investment process will remain the same. As of July month-end, U.S. REITs have generated 18.3% total returns and Global REITs have delivered 14.9% returns this year. Are these robust returns driven by the GICS-related buying or other factors? What are your expectations for REITs going forward? We suspect buying related to equity portfolio repositioning and increased awareness of REITs this year has had a modest impact on rising REIT stock prices. However, the more impactful factors this year are lower long-term bond yields, a slowing economy, and the market favoring investments with aboveaverage dividend yields and resilient income streams like REITs. With increased uncertainty in the market today, defense and safety have been widely favored over growth. Many investors view REITs as a safe investment that can generate attractive total returns in today s market environment. Improvement in real estate fundamentals has moderated this year as economic growth slowed but remains attractive relative to many industries. Low supply in the real estate market, firm employment levels, and contractual sources of earnings from leases are key reasons why real estate fundamentals are still healthy. We anticipate the current low interest rate environment will persist into the foreseeable future, supporting the somewhat elevated valuations of real estate. In this environment of steady fundamentals and low interest rates we anticipate the sector will continue to deliver attractive returns relative to other investment options. 4

5 Important Notes Unless otherwise noted, the information in this document has been derived from sources believed to be accurate as of August Information derived from sources other than Principal Global Investors or its affiliates is believed to be reliable; however, we do not independently verify or guarantee its accuracy or validity. Past performance is not necessarily indicative or a guarantee of future performance and should not be relied upon to make an investment decision. The information in this document contains general information only on investment matters. It does not take account of any investor s investment objectives, particular needs or financial situation and should not be construed as specific investment advice, an opinion or recommendation or be relied on in any way as a guarantee, promise, forecast or prediction of future events regarding a particular investment or the markets in general. All expressions of opinion and predictions in this document are subject to change without notice. Any reference to a specific investment or security does not constitute a recommendation to buy, sell, or hold such investment or security, nor an indication that Principal Global Investors or its affiliates has recommended a specific security for any client account. Principal Financial Group, Inc., Its affiliates, and its officers, directors, employees, agents, disclaim any express or implied warranty of reliability or accuracy (including by reason of negligence) arising out of any for error or omission in this document or in the information or data provided in this document. Any representations, example, or data not specifically attributed to a third party herein, has been calculated by, and can be attributed to Principal Global Investors. Principal Global Investors disclaims any and all express or implied warranties of reliability or accuracy arising out of any for error or omission attributable to any third party representation, example, or data provided herein. All figures shown in this document are in U.S. dollars unless otherwise noted. Indices are unmanaged and do not take into account fees, expenses and transaction costs and it is not possible to invest directly in an index. This document is issued in: The United States by Principal Global Investors, LLC, which is regulated by the U.S. Securities and Exchange Commission. The United Kingdom by Principal Global Investors (Europe) Limited, Level 1, 1 Wood Street, London EC2V 7JB, registered in England, No , which has approved its contents, and which is authorized and regulated by the Financial Conduct Authority. Singapore by Principal Global Investors (Singapore) Limited (ACRA Reg. No H), which is regulated by the Monetary Authority of Singapore and is directed exclusively at institutional investors as defined by the Securities and Futures Act (Chapter 289). Hong Kong by Principal Global Investors (Hong Kong) Limited, which is regulated by the Securities and Futures Commission and is directed exclusively at professional investors as defined by the Securities and Futures Ordinance. Australia by Principal Global Investors (Australia) Limited (ABN , AFS License No ), which is regulated by the Australian Securities and Investment Commission. This document is issued by Principal Global Investors LLC, a branch registered in the Dubai International Financial Centre and authorized by the Dubai Financial Services Authority as a representative office and is delivered on an individual basis to the recipient and should not be passed on or otherwise distributed by the recipient to any other person or organization. This document is intended for sophisticated institutional and professional investors only. In the United Kingdom this presentation is directed exclusively at persons who are eligible counterparties or professional clients (as defined by the rules of the Financial Conduct Authority). In connection with its management of client portfolios, Principal Global Investors (Europe) Limited may delegate management authority to affiliates who are not authorized and regulated by the FCA. In any such case, the client may not benefit from all the protections afforded by the rules and regulations enacted under the Financial Services and Markets Act 2000 This material is not intended for distribution to, or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation Copyright 2016 Principal Financial Services, Inc. Real estate investment options are subject to some risks inherent in real estate and real estate investment trusts (REITs), such as risks associated with general and local economic conditions, interest rate fluctuation, credit risks, and liquidity risks, including interest conditions on real estate values and occupancy rates. International and global investing involves greater risks such as currency fluctuations, political/social instability and differing accounting standards. Investing involves risk, including possible loss of principal. Insurance products and plan administrative services provided through Principal Life Insurance Co. Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc. Securities offered through Principal Securities, Inc., , Member SIPC and/or independent broker/dealers. Principal Life, Principal Funds Distributor, Inc. and Principal Securities are members of the Principal Financial Group, Des Moines, IA MM8819 t q7 5