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Breaking With Banks, Real Estate Promoted to Headline Sector

Breaking With Banks, Real Estate Promoted to Headline Sector

Any substantial change that impacts the world around us is usually accompanied by an intense public response.

But not this time.

When indices managers S&P Dow Jones and MSCI, Inc. decided to reclassify and promote public real estate companies into a new headline sector, it was largely ignored by financial and real estate outsiders. But the creation of the Real Estate sector, the 11th Global Industry Classification Standard (GICS) sector, is a pivotal step in recognizing the increased attention investors have given public real estate and raises concerns around how this new benchmarking standard will impact capital allocation and investment management strategies.

The GICS framework, established in 1999, was originally developed with 10 headline sectors, 24 industry groups, 67 industries and 158 sub-industries across which all publicly traded companies could be segmented into their appropriate peer group. Until the reclassification, which took effect in August 2016, real estate had been an industry class alongside banks, insurance companies and financial firms under the Financials sector. With the reclassification, two industry groups – Real Estate Management & Development and Real Estate Investment Trust, which relate to construction, owning and operating of property – were moved into the new Real Estate headline sector. The Real Estate Investment Trust industry group was renamed Equity REIT. However, Mortgage REITs remain in the Financials sector, a decision driven by the fact that the class acts as lenders via the purchase of debt and makes a profit on the repayment of debt.

The reclassification validates public real estate as a distinct asset class, which had been “lost amid the banks and brokers over the years,” David Blitzer, chairman of the index committee at S&P Dow Jones Indices, wrote in a recent blog post.

The new elevated status can improve awareness and understanding of the asset class – no easy feat. As an example, REIT reporting standards require disclosure of asset-level information, greatly aiding due diligence and risk mitigation, while banks often are not required to reveal the underlying collateral of the loans on its balance sheet. Greater clarity is typically a plus, because it provides a distinction between how each industry group generates and distributes earnings. As such, the risk and reward profile of equity REITs benefited the Financials sector with yield, low correlation to other financial assets and collateral diversification but also has a unique valuation process that requires specialized knowledge base, different from insurance and banking firms.

A particularly important benefit comes when considering how significant equity REITs have become for the economy. The equity market cap of listed U.S. equity REITs jumped from $9 billion to roughly $900 billion over the last quarter decade, according to the National Association of Real Estate Investment Trust (NAREIT). Demand could be further facilitated as funds and investor portfolios are rebalanced to remain within their mandates – a potential boost for equity REIT valuations. CBRE Clarion Securities suggested that capital flow in the $25 billion to $50 billion range was possible given uncertainties around how the change is perceived by market participants.

Risk comes as many investors and fund managers choose to follow a market-neutral philosophy in which they align the composition of their portfolios with that of the GICS components, which are changing. In the short term, a spike in volatility is plausible as strategies are realigned with the new GICS sector weightings or by adding confusion to the market place.

In the long run, reduced volatility and greater understanding of public real estate and the new Financials sector framework is a net positive.

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