What The New Real Estate Sector Means For Investors

by: Columbia Threadneedle Investments

By Melda Mergen

Real estate just became the 11th Global Industry Classification Standard sector. The move validates real estate as a distinct asset class and may prompt investors to rethink their equity allocation decisions going forward.

Companies that invest in real estate and whose shares are publicly traded on a stock exchange have finally gotten their own category within the Global Industry Classification Standard (GICS). Up until now, real estate had been lumped together with banks and insurance companies under the broad "financials" sector. The reclassification affirms that real estate is a separate and distinct asset class; it also recognizes that allocations to real estate investment trusts (REITs) and other real estate assets are advantageous for portfolio diversification.

Meaningful effect expected on stock market indices

The newly created real estate sector includes all equity REITs and real estate management and development companies. Mortgage REITs (companies that invest in mortgage-backed securities) will continue to be classified under the financials sector. The effect of this new sector is likely to vary across equity indices, but we expect the reclassification to have a substantial impact. For example, let's take a look at two benchmarks closely followed by equity investors: the S&P 500 and the Russell 2000 Value.

Before and after

In the S&P 500, real estate now has a market weight of over 3% - larger than both telecommunication services and materials.

Source: FactSet, as of 06/30/16

The change will be even more dramatic in smaller cap indices; real estate is now one of the largest sectors in the Russell 2000 Value, as well as a significant weighting in other small-cap Russell indices.

Source: FactSet, as of 06/30/16

Three potential outcomes for real estate securities and investors

1. Increased demand

Investors may be underweight REITs in part because the asset class was not a headline sector until now. That could quickly change as benchmark-sensitive investors adjust their portfolios to reflect the new real estate sector. According to Morningstar, there is over $4 trillion in ETFs and mutual funds benchmarked to the S&P 500. Even a small rebalance in benchmark-sensitive strategies could produce significant flows into real estate securities.

2. Higher visibility

Investors may have overlooked REITs when they were categorized in the financials sector. That's regrettable because REITs have shined relative to financials over the last 15 years.

REITs have dramatically outperformed other securities in the financials sector

Source: Citi Investment Research, 06/30/16

With their own headline sector, real estate securities stand to benefit from a raised profile and an investor base interested in more analysis and information on REITs. A potential uptick in visibility may also trigger more coverage on Wall Street.

3. Less volatility

Equity REITs have experienced periods of unintended volatility from investors transacting in financials sector ETFs and mutual funds. These vehicles are often traded frequently in reaction to global macroeconomic events. A common example would be trading in financials ETFs in anticipation of or reacting to changes in interest rates. Now that REITs have their own distinct sector, the group may experience smoother trading, which could dampen volatility in the sector over time.

Bottom line

Making real estate a GICS sector validates the continual development and growth of this asset class and may help it become more visible and better understood. By affirming that allocations to real estate have a place in a well-diversified portfolio, the new sector is very good news for investors.

Disclosure: None.

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