Can REIT ETFs Really Enjoy Independence?

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Includes: ICF, IYR, KBWY, ROOF, SPY, XLF
by: Zacks Funds

Real estate investment trusts or REITs, which have long been a part of the broader financial sector, get a free status from September 1 with the S&P Dow Jones Indices and MSCI Inc., forming the new Real Estate Sector under the Global Industry Classification Standard (GICS). The sector will now be renamed 'Equity REITs' while Mortgage REITs will continue to be a part of the financial sector.

This new 11th sector in the S&P 500 made up for about 20% of the financial services sector and had a market value of $609 billion as of June 30, per Wall Street Journal. The independent status is the result of increasing investors' focus on REIT stocks over time. Notably, REITs have provided an average 9.8% return annually since mid-2008, breezing past the 3.5% returns offered by bank stocks, according to Morningstar.

Opportunities Ahead

This separation is expected to make the real estate sector even more attractive to investors and lessen trading volatility. As a separate sector, real estate will have two industry groups: Equity REITs (with about 97% exposure) and real estate management and development companies.

The analysts see "as much as $19 billion in new demand," as funds that are currently not invested in real estate may seek to play the euphoria following this new status. In fact, as per London-based property firm Grosvenor Group, "REITs account for 4.4% of all U.S. equities, but only make up 2.3% of generalist fund managers' portfolios, leaving general equity funds underinvested in real estate by around 50%." These underinvested or non-invested group thus may increase allocation to REIT stocks on more clarity about the sector.

Is There Anything to Worry About?

What If Fed Hikes Rates?

First, the separation appears to come at a difficult time. With speculations of a Fed rate hike doing the rounds, the high-yielding real estate sector is expected to be hit hard. Interestingly, though REITs were a part of the broader financial market, the two react differently to a rise in interest rates. Financials stocks perform better in a rising rate environment while high-yielding real estate stocks normally underperform.

Overvaluation Concerns

Secondly, REIT ETFs have had a stellar run so far this year (as of August 30, 2016), as investors flocked to this space in search of higher current income. The PowerShares KBW Premium Yield Equity REIT Portfolio ETF (NYSEARCA:KBWY) - which yields about 5.71% annually - is up about 22.7% so far this year (as of August 30, 2016) compared with about 3% returned by the Financial Select Sector SPDR ETF (NYSEARCA:XLF) and over 6.9% gains realized by the SPDR S&P 500 ETF (NYSEARCA:SPY).

After scaling such highs, overvaluation concerns about REIT stocks are likely to surface. KBWY has a P/E of 45.9 times - the highest in the space, while the iShares U.S. Real Estate ETF (NYSEARCA:IYR) is among the lowest P/E REIT ETFs with 17.3 times. Even this 17.3 times P/E is also higher than 14.8x P/E possessed by XLF and 16.23x P/E offered by SPY.

A Few Bearish Analyst Sentiments

While many are bullish on the U.S. economic growth and the resultant positive impact on the sector, there are bearish theories as well. Goldman Sachs believes that "real estate stocks were a buying opportunity a few years ago, but at this point the area is too risky for investors." In mid-August, Goldman was Neutral on the Real Estate sector.

Tom Barrack, the billionaire chairman of Colony Capital Inc., also finds U.S. real estate market 'bubblicious'. His view is that many are betting on the real estate sector on higher rent outlook. But rent may not see a continued uptrend.

Wells Fargo Investment Institute deems declining investors' sentiments about real estate stocks, banks' stricter norms toward real estate lending and slower commercial real estate price gains are concerns. However, the research house is still supportive of the sector.

Bottom Line

Having said all, we would like to note that economic developments are not outright bearish. As the benchmark U.S. Treasury yield is still below 2%, rising rate concerns will not be that harmful for REITs as yet. Also, the economy is on the growth path, thus still keeping the demand for REITs steady.

A few ETF choices are the IQ US Real Estate Small Cap ETF (NYSEARCA:ROOF), the iShares US Real Estate (IYR) and the iShares Cohen & Steers REIT (NYSEARCA:ICF). These funds are relatively less overvalued with P/E ratios of 29.2, 17.3 and 21.2 times, respectively.

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