Learn more from Mike Gibbs, Managing Director of Equity Portfolio & Technical Strategy, about the impact of the Real Estate Investment Trusts (REITs) becoming a standalone sector of the S&P 500.
On September 1st, the Real Estate Investment Trust (REIT) subsector of the S&P 500 will become its own standalone sector, becoming the 11th S&P 500 sector. Since 1999, REITs have been a subsector of Financials, currently making up 3% of the S&P 500 and 19% of the Financials sector. Therefore on September 1st, the Financials sector will hold a 13% weighting within the S&P 500 (from 16%); and the REIT sector will stand alone as a 3% weighting within the S&P 500.
This requires fund managers and investors to assess the implications on their own portfolios in terms of sector exposure, diversification, etc. Portfolio weighting changes have undoubtedly been taking place as the September 1st date moves closer (the REIT sector announcement was made in March 2015), so we wouldn’t expect much dramatic movement on the day that this happens. That being said, the Raymond James Real Estate team notes that mutual fund weightings relative to the Russell benchmarks do show a current underweight picture for active managers in the space. Therefore, future fund rebalancing could have greater effects on the sector. As always, portfolio decisions should be based on your individual objectives and preferences. As such, individual exposures to the REIT sector will vary.
Overall Investment Outlook:
Our sector work incorporates fundamental trends, valuation, and technical momentum. Unfortunately, for several sectors (Utilities, Telecom, Consumer Staples, REITs, and Banks), the directional moves of interest rates have in the recent past been an important driver of investment returns. It is the potential movement of interest rates that temper our enthusiasm for the REITs despite favorable fundamental trends for the industry.
REIT relative performance has been -0.85 inversely correlated to interest rates over the past three years. It is important to note that this is more of a recent phenomenon however, as the 15-year correlation is 0.21. Due to global macro concerns, low inflation, and low growth, interest rates have remained stubbornly low. Because of this, the low volatility and high yield of the REITs has been attractive to investors. With Fed commentary becoming more hawkish recently, the biggest concern for the sector in the short term is the potential for a sharp rise in interest rates. Fed commentary will likely influence relative returns in coming months, and any surprise hikes could result in pressure on the REIT space due to their dividend yields becoming incrementally less valuable to investors.
Fundamentals: Funds from operations (FFO) have grown at an average 4.3% annual growth rate since 2002; and consensus estimates are looking for ~8% growth in 2017 and 2018, following 5.9% growth in 2016. That’s pretty solid growth for this lower beta sector (0.74 three-year beta). Dividend growth is also a major reason for investment in REITs (making up about half of annual returns for the sector over the past 20 years) and has been decent since 2002 with an average annual dividend growth rate of 3.5%. Since the credit crisis, however, growth has been more robust at an average rate of 15% since 2009. The RJ REIT team calculates 73 U.S. REITs that have increased dividends by a cap-weighted average of 7.6% in 2016 (10% simple average). Furthermore, the sector’s dividend payout ratio (based on FFO) is 73%, which provides the ability for dividends to continue to increase should FFO continue to increase as well.
Valuation: The REIT sector currently has a 3.81% dividend yield which is 217 basis points (bp) above the U.S. 10-Year Treasury yield and 167 bp above the S&P 500 dividend yield. Based on these spreads, REITs remain attractive to income-oriented investors. On a Price to FFO (funds from operations) basis, S&P 500 REITs trade at 19.5x- 6% above their 15-year average of 18.4x. Given the current interest rate environment, the group’s valuation is reasonable and not at extreme levels.
Technical: The S&P 500 REIT subsector has pulled back as much as 5.25% from its recent early August high, following a 28.8% rally from its mid-February low. The pullback was influenced, in part, by the recent increase in the odds that the Fed may hike interest rates this year. The odds of a December hike have jumped up to 58.6% (August 30, 2016) from 44.8% (August 15, 2016). The index remains above horizontal support (that it broke out of at the end of June); however, it is worth noting that its relative strength did recently breach trend line support, suggesting a more cautious approach toward the group.
Be advised that investments in real estate and in REITs have various risks, including possible lack of liquidity and devaluation based on adverse economic and regulatory changes. Additionally, investments in REIT’s will fluctuate with the value of the underlying properties, and the price at redemption may be more or less than the original price paid. Real estate investments can be subject to different and greater risks than more diversified investments. Declines in the value of real estate, economic conditions, property taxes, tax laws and interest rates all present potential risks to real estate investments. Dividends are not guaranteed and must be authorized by the company’s board of directors.