The decoupling of REITS from financials in global equity indices could lead to increased demand for listed real estate securities, says Paul van de Vaart.
The creation of a real estate sector in the global industry classifications standards (GICS) by equity index providers could boost flows into real estate investment trusts (REITS) as it becomes easier to identify the specific characteristics of REITS from the banks and insurance companies they have traditionally been grouped with. Furthermore, REITS are likely to experience lower volatility in a stand-alone index rather than being affected by flows into generally more volatile financials.
MSCI launched a distinct real estate sector on August 31, while S&P Dow Jones Indices did the same on September 16 during the provider’s annual index rebalancing exercise. The reclassification of REITS is long overdue given the differences in performance, risk and market drivers relative to other financial service sector companies.
Index rebalancing exercises are not unusual and generally see increased trading in new entrants to and rejects from an index as passive and active managers adjust portfolios accordingly. By clearly separating the performance characteristics of listed real estate stocks and making it simpler to add or remove the asset class from multi-asset portfolios, the traditional underweighting of the sector may soon be history.
REITs are listed securities offering a relatively low-cost, flexible and liquid way to gain exposure to real estate assets as opposed to buying the assets directly. The securities typically offer stable and predictable dividends due to their holdings of assets secured by long-term rental income contracts. Property funds frequently allocate to REITS as a way to boost their liquid assets, given the months or years it can take to sell commercial real estate assets.
Almost three-quarters of REITS (71.4 per cent1) are listed in the US, with Australia, France, Japan and the UK accounting for another 24.2 per cent1 of the market. With UK REITS representing less than four per cent of the global market, the UK’s vote to leave the European Union in June is expected to have a limited impact.
REITS and real estate are highly correlated over the long term: US REITS have had a correlation of 0.912 with US unlisted real estate since 1998, while the correlation with US large-cap equities is 0.542 over the same time, based on annual returns. However, over shorter holding periods, the REITs and equities are more correlated. Additionally, given the broader context of aggressive monetary easing by central banks and with yields on $13.4 trillion3 of sovereign and corporate bonds in negative territory; the asset class has been well supported by global investors’ hunt for return, generating a yield of 3.5 per cent1 as of September.
REITS equate to 18 per cent4 of financials on the S&P 500, and three per cent4 of the S&P 500 overall. Given the influence of exchange-traded funds and mutual funds investing in the S&P and MSCI indices, the reclassification of REITS is likely to have a sizeable impact as investors review their portfolio weightings.
Investing in a stand-alone REITS sector is likely to be less volatile and offer lower correlation to the market than investing in a financials index that includes the asset class. For instance, market participants like financials exchange-traded funds may trade the sector for reasons other than related to real estate fundamentals. Indeed, the 260-day volatility level of REITS has been around a quarter less than for financials4 since 2000, while the former has returned 262 per cent versus 41 per cent for financials. The long-term nature of rental income and the predominantly fixed financing costs of REITS operators impart a stabling influence on cash flows and can do likewise on their share prices.
Goldman Sachs expects the index reclassification to spur active managers to invest $19 billion5 in REITS, largely flowing from around the 40 per cent of large-cap ‘core’ fund managers with no exposure to the asset class. Meanwhile, Jeffries estimates6 that the average mutual fund is 3.3 per cent underweight the sector with each additional one percentage point uplift in allocations adding $46.7 billion of buying pressure in a $800 billion REITS market.
US mutual fund exposure to REITs is below its benchmark weights across the industry, with 17 out of the largest 20 active managed mutual funds underweight.
Over the short and medium-term, we expect positive investment flows as the characteristics of the sector become more apparent. For instance, potentially less volatility and lower short-term correlation with equities may encourage multi-asset investors to allocate more to REITS. Real estate has outperformed financials in 12 years out of the last 15 years in the MSCI World Index. Similarly, real estate has been a top-four sector performer in eight of the last 15 years. With European and Japanese central banks still aggressively easing monetary policy, the hunt for yield continues. In that context, REITS provide the potential to earn fairly reliable, often inflation-linked, income and income growth prospects that investors are desperately seeking.
1 Source: MSCI, MSCI World REIT Index (USD), 30 September 2016
2 Source: NAREIT Research, June 2016, data covers period from 1 January 1998 to 31 December 2014
3 Source: FT, 12 August 2016
4 Source: Barrons, 24 May 2016
5 Source: Bloomberg, 9 August 2016, 260-day moving average volatility and total return data covering 1 August 2000 to 31July 2016
6 Source: FT 25 April 2016
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 17 October 2016. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.