A historic shift in the Standard & Poor’s 500 index will occur mid-September when real estate will become its own sector, similar to other sectors like utilities, financials, energy and health care.
When S&P and MSCI jointly created the classification standards in 1999, they tucked real estate under the financial sector. Since then, real estate investment has quickly grown and now it accounts for 20 percent of the financial sector’s holdings. When it becomes its own sector, real estate will represent 3.25 percent of the entire S&P 500, with 28 names making the switch, says David Blitzer, managing director and chairman of the index committee for S&P.
This is the first time since 1999 that S&P and MSCI have added a new sector classification.
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Market watchers who follow real estate and the financial sector say it will allow real estate investment trusts like hotel REITs, office REITs and other physically based REITs to be valued on factors like cash flow, rents and building supply and demand. As part of the financial sector, physical REITs were often affected by factors that influenced banks and insurance companies, which may not have mattered to real estate. While the physically based REITs will move, mortgage REITs will stay with financials since their value changes based on interest rates.
“The classic definition of a sector is that you want all the stocks that trade in a similar way to be together. The REITs and true financials have gone separate ways at this point,” says Dan Dolan, director of wealth management strategies for S&P Select Sector SPDRs.
The official S&P and MSCI data bases will make the changes on Aug. 31, but the actual indexes will change after markets close Sept. 16, Blitzer said.
What investors should expect. Since the announcement last year, mutual fund and exchange-traded fund firms have been working toward a smooth transition so investors will likely see little impact from trading fees or tax implications by the sector switch.
For example, earlier this year S&P Select Sector SPDRs created a new ETF, Real Estate Select Sector SPDR Fund (ticker: XLRE) to reflect the new sector, which was spun out of its $15 billion Financial Select Sector SPDR Fund (XLF), the biggest financial-sector ETF based on assets under management, Dolan says.
Creating the new ETF was the most efficient thing to do, he says.
“When looking at the numbers, its $3 billion in REITs. It makes no sense in the open market to sell that and buy something else, so we’re trying to do it as efficiently as we possibly can. And working with $3 billion, how do you move that as efficient from a tax perspective, from a trading perspective,” he says, noting the new real estate ETF has about $50 million in assets under management as of late July as some investors are buying the fund ahead of the crossover.
Holders of the current SDPR financial ETF will receive new real estate ETF shares in proportion to their current holdings under a special distribution that “we anticipate to be tax friendly,” he says.
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Potentially more investor interest. Ed Cowling, director of specialty assets in the wealth management group at U.S. Bank in Texas, says portfolio managers are likely looking at their current holdings and probably are making new decisions about real estate.
“I don’t think there’s going to be a rush immediately overnight to rebalance their portfolios, but the REIT classification will be an important … as advisers consider the ranges of their investments. The managers will look at all their holdings, and the financial funds themselves will be under scrutiny,” Cowling said.
Paul Curbo, portfolio manager at Invesco Real Estate in Dallas, says real estate may start to gain some prominence now that it has its own sector.
Advisers “have been underweight real estate in all types of strategies — value, growth, small cap, mid cap, large cap — because real estate is somewhat unique. It has its own evaluation criteria so it’s been an area where portfolio managers just haven’t spent the time or focus on it,” he says.
Part of that is because valuing REITs can be tricky, he says. From an earnings multiple and earnings growth perspective, REITs can “look incredibly expensive,” which is likely why portfolio managers and generalist investors have traditionally been underweight REITs. The best way to value physically based REITs is to look at where the company is trading, relative to the value of its real estate, and to find out if it trades at a premium or discount to the underlying value of the real estate, he says.
REIT investors have traditionally sought the sector because of its high dividends, especially in the current low interest rate environment. That makes the timing of the real estate sector interesting, Dolan says, since the markets are waiting to see if the Federal Reserve will raise interest rates. In a rising interest rate environment, financial firms do better, while REITs underperform.
Real estate may see a flurry of interest as the new sector debuts, Curbo says, which may mean the potential for more money flows into the sector, boosting values. However, REITs may also disappoint in the short term if pent-up demand doesn’t show up as expected. He says investors need to look beyond the near term.
[See: The 10 Best REIT ETFs on the Market.]
“We might be in for a little bit of a period of volatility over the next few months, but in general real estate is tied to the underlying fundamental characteristics of the assets they own. Longer-term there is the potential for a reduction in volatility because real estate companies own real assets, real buildings and the real cash flow tied to them. There is some diversification benefits that the cycle of real estate is different than the general global economy,” Curbo says.
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Real Estate: How to Invest in Wall Street’s ‘New’ Sector originally appeared on usnews.com
