How large of an investment opportunity is being created by the upcoming Sept. 1 expansion of the familiar 10 major sectors with the debut of a new, 11th sector devoted to real estate, in benchmarks such as the S&P 500 and others run by S&P Dow Jones Indices and MSCI?
The impact could be big.
Real estate stocks — and the mutual funds holding many of them — stand to get a windfall infusion of billions of dollars. Diversified stock funds would have to buy more than $100 billion of REIT stocks to wipe out their real-estate underweights relative to their benchmarks, according to JPMorgan. Investors, including many of those funds, are already buying REITs, says Mike Grupe, executive vice president of research and investor outreach of the National Association of Real Estate Investment Trusts (NAREIT).
“That sort of inflow could drive up stock prices,” said Todd Rosenbluth, director of ETF and mutual fund research for S&P Global Market Intelligence. “Shareholders in funds holding real estate stocks could see at least a short-term bump up.”
That’s more likely to benefit shareholders in real-estate sector funds than U.S. diversified stock funds. Diversified funds are likely to be buyers, says Gregg Fisher, chief investment officer of investment management firm Gerstein Fisher and lead manager of three of its funds. Sector funds are already fully exposed to real estate.
Still, diversified funds that are underweight also might boost their real estate weighting, says J. Scott Craig, manager of $43 million Eaton Vance Real Estate Fund (EIREX). “If they hear from consultants and clients who look at fund reports (after Sept. 1) that show sector weightings, they might be pushed to act. Especially if their real estate weighting is still 0%, it could be a stark number.”
Many mutual funds are bulking up on real estate stocks, including REITs, because their respective investment mandates call for them to hew to some degree to their benchmark’s sector weightings, Grupe says. But no one knows how much in REIT stocks will eventually be bought, Rosenbluth says.
As a result of the change, which was decided in late 2014, real estate will be broken out from the financial sector, of which it is now part.
Real estate made up 2.45% of the S&P 500 Index and 3.19% of the MSCI ACWI global index as of March 31, according to Morningstar Inc. The average U.S. stock fund had a real estate weighting of 2.3%, compared with 4.4% for their benchmarks, as of Dec. 31.
“REITs will also draw money simply because of increased exposure,” Fisher said.
With more attention drawn to real estate, more investors will chase the group’s recent performance. Real estate funds were up 6.37% this year on average through June 16 vs. 0.82% for the average U.S. diversified stock fund, according to Lipper Inc. Also, they’re up 11.42% over the past 52 weeks vs. a 5.26% loss for U.S. diversifieds.
And REITs’ outlook is attractive to many investors. Economic growth, even if it is slow, props up demand for real estate, Grupe says.
And because share-price performance by real estate has a low correlation to stocks and bonds, real estate offers investors an attractive way to cut portfolio volatility stemming from those other asset classes.
For example, U.S. stocks averaged only a 0.55 correlation to U.S. REITs from 1990 through 2015, according to Cohen & Steers. That means their performance resembled those of REITs by only a little more than 50%. U.S. bonds had only a 0.19 correlation to REITs.
Fisher, whose investment approach is basically quantitative, says that CoreSite (COR) is a holding that illustrates the types of stocks that should draw new investor inflow.
He says the stock has attractive metrics, such as price momentum and relative valuation.
IBD readers are likely to notice that the stock has a 99 Composite Rating, the highest possible. The Composite Rating combines IBD’s five performance ratings, including EPS and Relative Strength ratings. Stocks poised to move higher often have a high Composite Rating.
It also has a 2.6% dividend yield.
Craig’s favorite segment going forward is apartment REITs. An expansion of supply amid slower revenue growth has hurt the segment, he says. But he likes Equity Residential (EQR) because it has been oversold. “Investors have been right about the direction of the impact of slower revenue growth but wrong about the magnitude,” he said.
Equity Residential’s focus is in coastal cities, where the apartment markets are strongest. New housing supply in those markets has hurt EQR’s fundamentals, he says, but only “quite modestly.”
AvalonBay is the biggest developer of apartment REITs, he says. And like EQR, it has heavy exposure to the “sexy six” — Boston, Manhattan, the District of Columbia, Seattle, San Francisco and Los Angeles. “These, I believe, are the six best long-term real estate markets in the U.S.,” he said. “They have highly educated work forces, high average household income, high cost of single-family housing, significant barriers to new construction and diversified economies. Those characteristics lead to greater rent growth and property price appreciation over the long term.”
Essex, he adds, is a West Coast pure play. Avalon and Essex have dividend yields of 3.1% and 3%, respectively.
In addition, he likes Federal Realty (FRT), a REIT with a 2.4% dividend yield, whose stock is not beaten down, he says. “This REIT’s portfolio includes a number of successful mixed-use properties, and it can add more of the same,” he said.
Grupe likes the office segment because new supply has been limited, he says, while demand keeps rising.
And he likes self storage. “We love our stuff,” Grupe says about Americans. Economic growth enables people to pay for storing it.