Between September 16th and 19th, a new sector will be introduced on Wall Street. Real Estate Investment Trusts (REITS) which own commercial real estate and generate dividends from the rents that are levied, will be split off from all other financial stocks where they have been listed alongside banks and insurers since 1999 when these sectors were created. REITS will become the 11th sector of the S&P 500, joining technology, health care, utilities and others.
Publicly traded real estate investment trusts are companies that own real estate but whose shares trade on an exchange like a stock and the new sector can put pressure on financial stocks as they have been one of the few successes on Wall Street this past year, helping to limit declines in the overall financial sector.
The MSCI U.S. REIT index, which tracks real-estate investment trusts, is up 6.7% in 2016 as opposed to financials that have been the third-biggest straggler in the S&P 500 during the same period, following health care and technology stocks and shedding more than 3% in 2016 versus the broader market’s 1% gain.
Best Sector Over last 15 Years
REITs have been by far the best-performing asset class in the market over the past 15 years but most actively managed fund managers have largely ignored these stocks. Since 2000, REITs have returned an average of 12% a year, according to J.P. Morgan Asset Management. That outdid by a long shot the no. 2 finisher--high-yield bonds—which came in 7.9% higher over the same period. Large-cap U.S. stocks returned 4.1%.
Shares in this sector have been attractive to investors this year as they have managed to pay out big dividends. REITs own a variety of properties, from single and multifamily homes to shopping malls and they are required to return most of their profits to shareholders and don’t have to pay taxes on that amount.
On the other hand, banks have been confronted with years of rock-bottom interest rates, which have greatly restricted their profits from loans. The KBW Nasdaq Bank index, a modified market capitalization weighted index designed to track the performance of U.S. regional banks or thrifts that are publicly traded in the U.S., is off 8.2% so far this year.
According to Morningstar Inc., investors have pulled out about $4.8 billion from mutual funds and exchange-traded funds that focus on financial companies this year through the end of March compared to a net $47.8 billion that has been deposited into mutual funds and ETFs in the first three months of the year.
40% of Funds Don’t Own REITS
Despite the positive performance of REITs, nearly 40% of large-cap core mutual funds, which largely invest in S&P 500 stocks, don’t own any REITs. According to Goldman Sachs, overall, funds with no REIT exposure have a total of $528 billion in assets while funds that do own REITs hold only 2% of their assets in the stocks, less than two-thirds of the sector’s weight in the market. Converting REITs into its own sector will show which managers are avoiding real estate.
Why have fund managers shied away from investing to in REITS until now?
REITs can be frustrating to investors because they fluctuate based on what’s happening in the economy. They perform well when the economy is zipping along at a modest pace, like now when rents are rising and occupancy is high. But when the economy crashes, they can get hit hard. In 2007 and 2008, REITs lost 15.7% and 37.7%, respectively.
When the economy moves too fast and interest rates rise, REITS lag behind, acting more like bonds than stocks and they are often compared with utilities which also throw off lots of dividends but not much more.
New Sector Can Bring Change
All of this is should change now that the sector has been given its own position. Indeed, the fortunes of both the financial and the REITS sectors could change even before the new division goes into effect in September. The sell-off in financial stocks have made them cheaper and they are currently trading at 12.4 times the last 12 months’ earnings, making stocks the least-expensive sector in the S&P 500. This may bring financials back into the limelight.
In addition, despite the fact that there was considerable change in the industry and many REITs now own a host of office buildings, shopping malls and apartments, investors understand that the big gains recorded by REITs over the past 15 years will not be able to be sustained and although REITs have been the best-performing asset class in five of the last six years, this is unlikely to happen again.
The new REITs sector however, can bring an increased awareness of the unique risk-reward characteristics of REITs to investors and fund managers and could lead to greater performance differences across the other sub-segments.