Public real estate companies have underperformed the broader market in the months since S&P Dow Jones Indices and MSCI gave them their own sector classification, partly because the move coincided with widespread expectations of higher interest rates, observers say.
The new classification, which took effect at the close of trading on Aug. 31, carved out a real estate sector in the Global Industry Classification Standard. Previously REITs were included in the financials sector, which meant generalist investors did not necessarily have to take a specific view on the space in order to track their benchmarks.
The new sector's creation, following lobbying from prominent REIT industry figures, was expected to draw new scrutiny to real estate companies — and new investment dollars, as generalists shifted their allocations to track real estate's performance.
New attention did indeed come, and REITs outperformed the broader market in the months leading up to the change. But the move's timing may have worked against the new sector in the short term, because the GICS change took effect at a time when investors were preparing for a rise in long-term interest rates.
Many generalist investors believe REITs suffer when interest rates rise, though many REIT specialists, including analysts and investors dedicated to the sector, say that view lacks nuance. Either way, observers say the generalists paying closer attention to the sector in 2016 may have grown worried towards the end of the year.
The new sector legitimized the real estate industry in some investors' minds, but also introduced vulnerability, Mizuho Securities USA Inc. analyst Richard Anderson said in an interview. In the minds of investors less familiar with the sector, REITs are "a yield play first, second and third, and then you start talking about fundamentals," Anderson said.
Besides a growing belief that the Federal Reserve would raise rates — which it eventually did, in December — investors were seeking to adjust for the surprise election of Donald Trump as president. The 10-year Treasury note's yield has risen more than 40 basis points in the period since Trump's election, amid expectations that he will pursue inflationary policies.
"If you take the time period from the GICS implementation until today, you have the increased focus on higher interest rates, and then the election actually moving rates higher, and then most recently the Fed increase," Steve Shigekawa, senior portfolio manager at Neuberger Berman, said in an interview. "When you put that together, that becomes one of the main areas of focus for REIT investors: How will the sector perform in the face of higher interest rates in 2017?"
Because REIT share prices had appreciated in the period leading up to the GICS change, investors wary of rate increases may have been concerned about valuations around the time the new sector was created, Shigekawa said.
Both Shigekawa and Anderson said the view that REITs suffer when rates rise is incomplete, arguing that the broader economic growth the often follows periods of rising rates is good for broader real estate fundamentals. The last five sustained periods of rising rates were followed by periods of REIT outperformance — a pattern that suggests that the latter two-thirds of 2017 could be another REIT bull market, Anderson said.
Whether generalist investors come to adopt the view that REITs can thrive amid higher rates is an open question. Anderson argued that investors who have been studying REIT performance more closely after the GICS change may develop a more subtle understanding of their historical performance — a positive development that could make REITs' recent pain worthwhile.
"If we can get more investor base that is more knowledgeable about the fundamentals of commercial real estate, that will ultimately be good for the space," he said. "These are real operating organizations with unique real estate strategies and very dynamic management teams. They're much more than just yield plays, and if we can remove some of that lack of knowledge out of the investor cohort and replace it with people that understand the nuances of real estate fundamentals, I think that's ultimately a good outcome."
S&P Dow Jones Indices and S&P Global Market Intelligence are both owned by S&P Global Inc.