August 31, 2016. This day has been highly anticipated by REIT professionals and investors alike since last year’s announcement that exchange-listed Equity REITs will be elevated into a separate headline sector in the Global Industry Classification Standard (GICS). In the future, the REIT Industry may look back on 2016 in the same way that it regards 1960, 1986 and 2001. Those years represent watershed moments in the development in the REIT industry; the formation of REITs by Congress in 1960, the Tax Reform Act of 1986, and the REIT Modernization Act of 2001. The GICS reconfiguration will take place after the market close on Wednesday, August 31. The changes will be implemented by MSCI and S&P Dow Jones Indices as part of their annual index rebalancing on Sept. 16, 2016. Mortgage REITs, which facilitate the financing of commercial and residential real estate by buying mortgages and other real estate securities, will remain in the Financials sector.
Established in 1999, the GICS serves as one of the primary classification systems for investment managers worldwide, providing a means of organization and frame of reference for the development of funds, ETFs, and other products. It also provides a structure for investors, analysts and economists to consistently identify and analyze investment performance and economic activity, as well as to develop investment policies, products and research.
Wednesday’s reconfiguration represents the first time that a new headline sector will be added to the GICS since its 1999 launch, bringing the GICS to 11 headline-level sectors. Simply, listed Equity REITs and real estate companies will no longer be a niche, but rather representative of the distinct asset class that real estate is. Michael Knott, director of U.S. REIT research for Green Street Advisors, has described the upcoming reconfiguration as a “momentous event for the industry.”
The reorganization will release Equity REITs and other real estate companies from their longtime home within the Financials sector. To illustrate the appropriateness of this move, Equity REITs managed just over $120 billion when the GICS was created in 1999. That figure now stands at more than $900 billion. Despite the excitement, the true benefits of the reconfiguration will likely come over the long term, with little to no immediate effects. Nonetheless, investors who enjoy the dividends and steady returns of REITs should celebrate this affirmation that allocations to real estate and Equity REITs are fundamental to a diversified portfolio. To them and the industry, the creation of a separate real estate sector simply acknowledges what they have known all along; that there are fundamental differences between real estate companies and other businesses, including financial companies.
Similar moves have provided a boon to the real estate sector before. The last such time that a reclassification affected equity REITs was in 2001, when S&P decided to include REITs in its indexes for the first time. Sam Zell’s Equity Office Properties Trust became the first equity REIT included in the S&P 500 index, which is considered the most comprehensive benchmark for American corporations. Since then, the total equity market capitalization of exchange-listed equity REITs has risen to more than $900 billion, and as of August 2016 the S&P 500 includes 26 REITs.
One particular factor in the decision to reconfigure the GICS was the robust performance of REITs during and in the wake of the 2008 financial crisis. In short, most REITs outperformed many other sectors during a crisis that was ironically centered around a sector of real estate; housing. To be sure, there were a number of REITs that were overleveraged and either declared or teetered on bankruptcy in 2008-09, of which shopping mall REIT General Growth Properties was the most famous example. Yet, the REIT sector sold off, but it didn’t implode. More tellingly, it’s robust performance since has illustrated its long-term appeal.
Another factor that caught the attention of S&P and MSCI (which manages GICS) has been the increasing global appeal of the REIT corporate structure. Numerous countries have adopted REITs as a form of corporate organization, the latest having been adopted in Spain, Dubai and India. This increased attention and capital investment to the sector could incentivize more private real estate companies to go public or merge into existing listed REITs. Despite the US Government’s tightening of standards for firms to be classified as REITs, the GICS reconfiguration could encourage more companies to convert to REITs, taking advantage of its efficiency in delivering income to shareholders.
A dedicated GICS Real Estate Sector will have many benefits in the near term. First, it means that Equity REITs should receive more attention from institutional investors, individual investors and financial advisors, and increased visibility could result from more investment plans embracing REITs. For example, many 401(k) plans currently offer REITs as an option, but only for “alternatives” allocations. The GICS reclassification could drive greater allocation as more plan managers seek to provide the diversification benefits of real estate for portfolios. Second, while REITs have resisted the connotations of being a “niche” investment, some generalist investors struggle to understand the unique characteristics of their operations and performance. Finally, having headline-level status for the Real Estate Sector should generate better understanding surrounding many real estate industry-specific terms such as FFO (Funds from Operations) and NAV (Net Asset Value). Other common misconceptions, including the notion that REITs are a proxy for the housing market, could also be dispelled, according to investment firm Cohen & Steers.
There could be several long-term benefits stemming from the reconfiguration as well. First, REITs could experience lower volatility and greater liquidity. When REITs separate from the Financials sector, they will no longer be caught up in the trading of financial ETFs, which many investors use to speculate or hedge against risk – real or perceived – in the global financial system. In addition, NAREIT, the REIT industry professional organization, has suggested that “with a larger and more diverse investor base, the reclassification may also help further moderate the severity of real estate market cycles, with attendant benefits for the broader economy.” Second, the distinction and visibility of real estate investment could drive fund managers to create new investment products, such as active and passive mutual funds and exchange-traded funds focused on the new Real Estate Sector. As a result, financial advisors and fund managers will have more real estate investment options to recommend to clients, which could encourage and facilitate positive capital flows into listed real estate equities.
Real estate being viewed as a top-line asset class will bring with it additional considerations, some of which could cause growing pains for the industry. One such consideration is increased attention from activist investors. While there are already activist investors and shareholders who focus on REITs, status as a standalone sector may lead activists to examine the component REITs individually, spending more time looking at them than when they were part of the larger financial sector. The laggards in the sector could be more closely scrutinized, and those REIT managers could come under greater pressure than in years past. Another consideration is the uncertainty surrounding interest rates. Currently, there is a great divergence of opinion on whether rates are going to increase significantly over the next couple of years, and it could be a challenge for REITs to manage that while maintaining their dividends. If interest rates spike as the Federal Reserve continues to normalize US fiscal policy, some REITs could be hard-pressed to adjust. On the other hand, if the Fed opts for a gradual, linear, 2004-06 type of increase, managers may be able to better factor higher rates in.
Uncertainties aside, the bottom line is that the amount of subsequent investment into REITs post-GICS could be meaningful, with estimates ranging from $30 billion to $100 billion in new capital entering the industry as equity funds that have been underweight in real estate look to achieve a market-neutral position in an asset class that has outperformed the S&P 500 over the previous 10-, 20- and 30-year periods, including 7 of the past 10 years.
