Partner and Senior Financial Planner Laurie Belew takes a look at the recent reclassification of real estate within the GICS, and what impact that could have on the average investor:
The Global Industry Classification Standard (GICS) was developed in 1999 to assist the financial community in establishing a global standard for categorizing all major public companies. For the first time since its creation, a new sector classification will be added, elevating real estate to become the 11th GICS sector.
As of this month, equity real estate investment trusts (REITs) as well as real estate management and development companies will be moved out of the financials sector and assigned to the newly created real estate sector. Experts believe this change will have significant implications due to the wide-spread use of the GICS framework for both portfolio management and investment analysis.
These changes were put in place to both reflect the role of real estate in global markets, as well as to recognize that real estate has distinct characteristics from other businesses, including financials.
What does this mean to you as an investor? Well, REITs are likely to benefit from this new classification in terms of increased demand, reduced volatility, and potential changes in investor allocations.
Increased Demand. The new classification will raise the profile of real estate as an asset class. In turn, we expect more media coverage and general awareness of real estate’s attractive investment features. With more exposure, comes higher demand and more capital investment. Relative to market weight, real estate has, on average, historically been underweight.
Long-only equity mutual funds have an average underweight to real estate of 2.1%. “Based on $5 trillion in assets under management, it would take over $100 billion to move to a market-neutral position. To put that into context, this represents more than 12% of the total value of the U.S. REIT market.”
If investors increase their allocations to real estate, even just to market weight, it could produce a significant tailwind for the asset class.
Reduced Volatility. With increased demand and more extensive ownership, real estate stocks should see improved liquidity, leading to better pricing and increased stability. Further, separation from the volatile financial sector, may help to dampen uncertainty. In the long run, this could improve the risk side of the risk-return relationship.
Impact on Real Estate Allocations. Real estate is not being added to market indexes, it will simply be categorized differently, in turn increasing awareness and underscoring the need for specialist managers. Real estate analysis requires unique expertise, including understanding of specific valuation metrics and distinct property markets. Historically, REIT specialists have delivered a performance advantage over generalist equity managers.
A change unrelated to the GICS classification may also provide some tailwinds for the real estate markets. In December 2015, new legislation changed the Foreign Investment in Real Properties Tax Act (FIRPTA). Now, qualified foreign pension funds can own twice as much listed U.S. REITs than before, as long as a REIT satisfies the conditions of being domestically controlled. This is an interesting opportunity for foreign investment in U.S. real estate companies— which will likely lead to stronger demand for REITs, better financing costs, and more access to capital.
Real estate has been an important part of FJY client portfolios and we do not expect any immediate changes as a result of the GICS classification. We have long understood, and benefited from, the attractive performance of the asset class and the diversification benefits it offers.
Additional details can be found in Real Estate in a Class of Its Own, by Thomas Bohjalian, CFA.