How REIT investors, both institutions and generalists, are — and are not — reacting to real estate becoming a new GICS sector.
BY THE TIME YOU read this, the market will have already begun to digest the impact of what some might say is a long-overdue recognition of the commercial real estate industry. On September 1, 2016, the market opened with a new official sector within the Global Industry Classification Standard (GICS), following the Dow Jones Indices’ elevation of real estate from a subsector under “financials.”
As of early July, however, the potential impacts of this shift were unclear, based on a surprising lack of any buzz about it during REITWeek 2016, the National Association of Real Estate Investment Trusts’ (NAREIT’s) annual institutional investor forum. This attendee emerged from the conference without any sense of a strong viewpoint on the topic among institutional constituents. There seemed to be a palpable absence of attention to the impending real estate reclassification.
Christopher Lucas, managing director and senior real estate analyst with Capital One Securities, said he and his team queried REIT management teams on their views of the potential impact. Responses, he noted, were “all over the place” on a scale of one to 10, representing no impact to significant impact, respectively. Likewise, it was his sense that “buysiders,” though more focused on the topic, were also “very diverse” in their views.
Tom Lesnick, also an analyst with Capital One, noted that over the past six months he had sensed a growing interest in REITs among generalist investors, relative to the REIT-dedicated crowd. He indicated that this may not necessarily be related to the GICS reclassification, but rather to typical generalist behavior, which tends to focus more on multiples and dividend yields and less on net asset values. Said Lesnick: “Examples that come to mind [that could be generating interest among generalists] include:
1) The outperformance of the industrial sector due largely to e-commerce and multiples that looked relatively cheap despite trading at significant premiums to net asset value (NAV).
2) The underperformance of apartment REITs due to oversupply and multiples that looked relatively expensive despite trading at significant discounts to NAV.
3) The outperformance of small- cap REITs that are perceived by REIT-dedicated investors as lower quality, but offer high (albeit barely covered) dividend yields and attractive multiples, despite trading at significant premiums to NAV.
It seems clear that market participants may be viewing the reclassification as nothing more than a retrospective acknowledgement that the maturation of real estate in the public markets no longer relegates real estate to an “alternative” asset class.
Thus, the better questions to ponder are where is real estate heading, what will be the key catalysts and where will the GICS reclassification rank among those?
Key Investment Catalysts
Experts could undoubtedly argue about ordinal importance, but most analysts could be expected to place global funds flow as a top-three driver of commercial real estate performance in the near term. Even before the Brexit fallout and related concerns about the solidarity and/or fragility of the EU, the ongoing refugee crisis and slowing economic growth in China were already positioning the U.S. as a continued safe haven for investing.
In addition, recent changes to the Foreign Investment in Real Property Tax Act (FIRPTA) that lessen or in some cases eliminate tax burdens on foreign investors in real estate should propel increased investment into U.S. commercial real estate. Scale is important here, too: the California Public Employees’ Retirement System (CalPers), the largest U.S. fund (after the Social Security Trust Funds), is just number nine when ranked with the world’s largest sovereign wealth funds, according to the Sovereign Wealth Fund Institute. Thus, it stands to reason that foreign investment in U.S. real estate should at least support, if not drive, healthy asset valuation.
Commenting on future capital flows to CRE, Doug Opalka, a senior managing director at HFF, wrote in an e-mail that marginal increases of just 1 to 2 percent of overall allocations toward U.S. real estate from large sovereign funds represents a tidal wave in real dollar terms. “The top 10 [sovereign funds] represent almost $6 trillion in assets under management, so a move of just 1 percent toward U.S. real estate would be another $60 billion.” He went on to provide a frame of reference, indicating that “the total transaction market in the U.S. [in 2015] was roughly $440 billion, of which approximately $87 billion came from foreign investors.” As a point of comparison, he noted that “… the foreign total in 2007, often referenced as the last peak, was only $46 billion.”
Another top-three driver in the near term is the upcoming U.S. presidential election. What little discussion of GICS that took place at REITWeek was more than eclipsed by views on the election. Anecdotal consensus suggested that of the two presumptive nominees, Clinton would prevail. What was surprising, given the typical Republican leanings of real estate industry players, was that many thought Clinton should prevail.
The third of the top-three near-term drivers is the outlook for interest rates. Reflecting the first two catalysts, the U.S. continues on its “Goldilocks” path, not too hot and not too cold on an absolute (i.e., domestic) basis, and just right on a relative (i.e., global) basis. Taken together, these catalysts should bode reasonably well for the real estate sector.
Modest Impacts Expected
You’ve probably noticed that the GICS reclassification does not appear among the top-three near-term drivers. This is because the immediate impact of this reclassification will likely be modest. Henceforth, analysts, investors, industry executives and other CRE professionals can only contemplate the impact of the long haul. Real estate as its own GICS sector will likely continue to be a reflection, rather than a driver, of real estate investment trends.
Said differently, real estate becoming its own sector within GICS is simply the next step in a long line of tests (i.e., surviving the financial crisis) and validations (i.e., being added to the S&P 500) that increasingly provide comfort to investors that commercial real estate in general and REITs in particular are mainstream investments. Real estate has, indeed, come into its own.