On September 19, 2016, S&P Dow Jones and MSCI, Inc. added a sector for Real Estate. Up to this point, REITs have traditionally been considered a sub-industry and part of the Financial sector, but as of the market close on August 31, 2016 (and effective September 19, 2016), they were split from the Financial sector and moved to their own sector (with the exception of Mortgage REITs). This should not be a surprise for investors, as the change had been announced by index providers, S&P Dow Jones Indices and MSCI, back in March 2015.
What are REITs?
Under U.S. Federal income tax law, a REIT is “any corporation, trust or association that acts as an investment agent specializing in real estate and real estate mortgages.” Therefore, a REIT is a company that owns, and in most cases operates, income-producing real estate. REITs own many types of commercial real estate, ranging from office and apartment buildings to warehouses, hospitals, shopping centers, hotels and even timberlands. Created by the U.S. Congress in 1960, REITs were designed to provide a real estate investment structure similar to the structure mutual funds provide for investment in stocks. As such, they provide investors with a convenient and liquid way to invest in real estate. Because a REIT is entitled to deduct dividends paid to its investors, it may avoid incurring all or part of its liabilities for U.S. federal income tax—the purpose is to avoid double taxation of the income produced by the underlying properties.
In return, REITs are required to distribute at least 90% of their taxable income into the hands of investors. This makes REITs particularly interesting for income-oriented investors and has contributed to their popularity in recent years. The behavior of REITs in terms of returns and volatility tends to fall somewhere in between stocks and bonds; their focus on income puts them in somewhat direct competition with fixed income instruments, which means they tend to benefit from falling interest rates. However, since the income they produce is derived from real assets, REITs can also provide a good hedge against inflation.
Why are REITs becoming a sector?
Back in 2001, REITs represented about 0.11% of the market capitalization of the S&P 500 index. Today, that figure has grown to approximately 3%. While 3% may not sound like much, it is roughly comparable to the size of three other sectors of the S&P 500 index, specifically Utilities, Materials, and Telecommunications. The decision to promote REITs to sector status is a strong indication that REITs are very grown up. Indices are supposed to reflect the composition of the economy, and REITs are now a big part of it.
What are the implications of the change?
In terms of the investment merit of REITs and the decision as to how much of them you should own, we do not believe the reclassification should matter. REITs have been part of the S&P 500 index—arguably the most well known and invested stock index in the world—for a long time, and their popularity among the investment public has already been increasing in recent years. Being promoted to sector status may contribute to a further boost in their popularity, but it is unlikely to cause significant change. Real Estate has typically been held within our portfolios, but it has been housed within another sector. The reclassification does not change the fundamental reasons for owning it.
At Pinnacle, we own a financial sector ETF (XLF) that contained real estate investments and therefore gave our portfolios the exposure we desired. On September 19, XLF spun-off its real estate holdings and created a new real estate sector ETF, now known as XLRE. As a result, our clients will now own both XLF (invested in the financial sector) and XLRE (invested in the real estate sector). So in other words, clients now own two ETFs to represent the holdings they used to have in one ETF. On September 22, all Pinnacle portfolios will properly reflect the changes and the value of each holding.