Will REITs Prosper in Their Own Sector?

real estateFrom Zacks Research: As Standard & Poors gets set to jettison REITs from financials into their own sector, it pays to examine current valuations and weigh the risks.

Real estate investment trusts or REITs, which have long been a part of the broader financial sector, get a free status from September 1 with the S&P Dow Jones Indices and MSCI Inc., forming the new Real Estate Sector under the Global Industry Classification Standard (GICS). The sector will now be renamed ‘Equity REITs’ while Mortgage REITs will continue to be a part of the financial sector (read: What ETF Investors Need to Know About the New Real Estate Sector).

This new 11th sector in the S&P 500 made up for about 20% of the financial services sector and had a market value of $609 billion as of June 30, per Wall Street Journal. The independent status is the result of increasing investors’ focus on REIT stocks over time. Notably, REITs have provided an average 9.8% return annually since mid-2008, breezing past the 3.5% returns offered by bank stocks, according to Morningstar.

Opportunities Ahead

This separation is expected to make the real estate sector even more attractive to investors and lessen trading volatility. As a separate sector, real estate will have two industry groups: Equity REITs (with about 97% exposure) and real estate management and development companies (read: 3 Real Estate ETFs to Play Brexit Fears).

The analysts see “as much as $19 billion in new demand”, as funds that are currently not invested in real estate may seek to play the euphoria following this new status. In fact, as per London-based property firm Grosvenor Group, “REITs account for 4.4% of all U.S. equities, but only make up 2.3% of generalist fund managers’ portfolios, leaving general equity funds underinvested in real estate by around 50%.” These underinvested or non-invested group thus may increase allocation to REIT stocks on more clarity about the sector.

Is There Anything to Worry About?

What If Fed Hikes Rates?

First, the separation appears to come at a difficult time. With speculations of a Fed rate hike doing the rounds, the high-yielding real estate sector is expected to be hit hard. Interestingly, though REITs were a part of the broader financial market, the two react differently to a rise in interest rates. Financials stocks perform better in a rising rate environment while high-yielding real estate stocks normally underperform.

Overvaluation Concerns

Secondly, REIT ETFs have had a stellar run so far this year (as of August 30, 2016) as investors flocked to this space in search of higher current income.PowerShares KBW Premium Yield Equity REIT Portfolio ETF (KBWYETF report) – which yields about 5.71% annuallyis up about 22.7% so far this year (as of August 30, 2016) compared with about 3% returned by Financial Select Sector SPDR ETF (XLFETF report) and over 6.9% gains realized by SPDR S&P 500 ETF(SPYETF report) .

After scaling such highs, overvaluation concerns about REIT stocks are likely to surface.  KBWY has a P/E of 45.9 times – the highest in the space, whileiShares U.S. Real Estate ETF (IYRETF report) is among the lowest P/E REIT ETFs with 17.3 times. Even this 17.3 times P/E is also higher than 14.8x P/E possessed by XLF and 16.23x P/E offered by (SPYETF report) (see all Real Estate ETFs here).

A Few Bearish Analyst Sentiments

While many are bullish on the U.S. economic growth and the resultant positive impact on the sector, there are bearish theories as well. Goldman Sachs believes that “real estate stocks were a buying opportunity a few years ago, but at this point the area is too risky for investors.” In mid-August, Goldman was Neutral on the Real Estate sector.

Tom Barrack, the billionaire chairman of Colony Capital Inc., also finds U.S. real estate market ‘bubblicious.’ His view is that many are betting on the real estate sector on higher rent outlook. But rent may not see continued uptrend.

Wells Fargo Investment Institute deems declining investors’ sentiments about real estate stocks, banks’ stricter norms toward real estate lending and slower commercial real estate price gains are concerns. However, the research house is still supportive of the sector.

Bottom Line

Having said all, we would like to note that economic developments are not outright bearish. As the benchmark U.S. Treasury yield is still below 2%, rising rate concerns will not be that harmful for REITs as yet. Also, the economy is on the growth path, thus still keeping the demand for REITs steady.

A few ETF choices are IQ US Real Estate Small Cap ETF (ROOFETF report) ,iShares US Real Estate (IYRETF report) and iShares iShares Cohen & Steers REIT (ICFETF report) . These funds are relatively less overvalued with P/E ratios of29.2, 17.3 and 21.2 times, respectively.

This article is brought to you courtesy of Zacks Research.

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