REITs get their dayWhat an index sector breakout of REITs could mean for shares in the short and long term
August 4, 2016
With major index publishers like MSCI and Standard & Poor’s (S&P) planning to separate real estate investment trust (REIT) securities into their own unique sector at the end of August, REITs will no longer be included in the financials sector, where they have long been classified. This split speaks to the growing relevance of the real estate sector, and we think it could potentially influence how investors behave toward REITs. Here are two important reasons why:
- Asset managers will now have to be more explicit in how they justify their REIT positions relative to their benchmarks. This could result in certain asset managers initiating new REIT purchases or slightly increasing existing allocations. This buying activity could be a positive for flows into the asset class, but we think there’s a chance it could come at a price: an uptick in volatility.
- With REITs no longer effectively “hidden” within the financials sector, investors may become more consciously aware of their unique characteristics, such as their potential for competitive yields, dividend growth, and inflation protection. One result could be an increased interest in REITs. As in the case above, this source of increased demand could contribute to a measurable (if temporary) rise in volatility.
Short-term demand surge?
If REITs do indeed generate more interest from investors as a result of the changes, the amount of money in motion will be difficult to estimate. What seems to be more certain is that investment strategies based on MSCI and S&P indices will likely see their REIT holdings adjusted, considering that generalist equity managers often underweight the REIT sector. What’s more, elevating REITs to a headline sector that’s distinct from other financial stocks could help position them as a legitimate stand-alone asset class. This generally could lead to an uptick in demand for REIT shares over time, independently of any benchmark-related, short-term portfolio adjustments.
Familiarity breeds lower correlations
As noted above, we think these index changes generally leave REITs poised to become more widely known among investors after reclassification. Heightened familiarity could bring another important positive for REIT price behavior: less correlation with the financials sector.
This would be a reprieve from a phenomenon that has been particularly apparent during times of market stress. For example, looking back at the onset of the global financial crisis, Bloomberg data show REITs and financials moving together closely, with a correlation coefficient that reached beyond 0.8 (a correlation coefficient of 1.0 occurs when two assets move in perfect lockstep). We think such high correlation of returns is partly explained by investors’ tendencies to view REITs as having financial profiles reasonably similar to companies like banks and insurers. But a look at one financial measurement — leverage — shows how misleading this thinking can be. While REITs usually employ somewhere between 30% and 40% leverage (measured as a percentage of total assets), traditional financial services firms are typically extending themselves much further, running up leverage that often goes well beyond 100%.
The relatively lower leverage readings shown by REITs are important, because they show that REITs tend to be less dependent on borrowing. And by relying less on debt, REITs reduce the likelihood of eating away at revenue in order to make interest payments.
New image is a long-term positive
Our everyday research focuses on company fundamentals, together with the cost and availability of credit. But occasionally an industry development can move the needle on technicals. In the case of the REIT index reclassification, we think there may be some noise around the transition in August, but once any initial rebalancing is complete, investors will be able to step back and see REITs in a new light — something that could be a positive in the longer term.
The views expressed represent the Manager's assessment of the market environment as of July 2016 and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views. The investments referenced herein may not be suitable for all investors.
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The correlation coefficient measures the relationship between the movements of two variables. When two variables tend to move together, they are said to exhibit a high correlation. When they tend to move independently of each other, they are said to exhibit a low correlation. The coefficient is expressed as a value between -1 and +1. Readings that are 0.8 or above are generally described as strong, while readings below 0.5 are generally described as weak.