Real Estate has been one of the best-performing asset classes in 2016. Vanguard's REIT index (VNQ), which is one of the bigger and more high-profile funds of Real Estate Investments Trusts (REITs), is up 14.8% so far this year, which is way ahead of the broad stock market's (Wilshire 5000) gain of just 3.5%.
Some of this exceptional performance is easily explained. As this SMI primer on REITs details, the commercial real estate market interacts with interest rates in two important ways. First, real estate deals normally begin with significant borrowing up-front. Lower interest rates bring the borrowing costs of these deals down, making them more profitable for the companies that run these REITs. Secondly, REITs are viewed as an alternative to bonds by income-seeking investors. As bond interest rates fall, REIT yields are more attractive by comparison. With the 10-year Treasury bond hitting an all-time low below 1.4% this week, VNQ's yield of nearly 3.3% looks pretty attractive.
So falling interest rates throughout 2016, coupled with a relatively weak stock market, explain a good deal of the strength in REITs this year. But there's another factor that may be providing REITs with a tailwind as well.
In November of 2014, Standard & Poor's and MSCI, two of the largest benchmark providers for ETFs and other investment products, announced they were going to split real estate out of the "Global Industry Classification Standard" Financial sector in order to create a new stand-alone Real Estate sector. This was a fairly big announcement, as it was the first time the 10 original GICS sectors had been altered since the current format was established in 1999. To separate real estate out and have it become the 11th official GICS sector was recognition of real estate's higher profile and an indication that money managers ought to be paying attention to the sector.
As for tangible investment impact, S&P said in a note out yesterday, "Many portfolio managers and mutual funds compare their equity asset allocation against the current 10 sectors in GICS. When real estate becomes its own sector, these portfolio managers may be busy rebalancing to assure their real estate exposure isn’t too far from the benchmark."
It's hard to say exactly what this means for REIT investments. One estimate early this year by JPMorgan Chase & Co. indicated fund managers could add as much as $100 billion to REITs this year, based on the idea that funds only own about half the REIT stocks they would if they wanted to mimic the S&P 500 weights. But others expect much less of an impact.
And perhaps most importantly, this change was announced in November of 2014 and won't be effective until August 31 of 2016. Which means the marketplace has had a lot of time to prepare for this. It's anybody's guess as to how much of this move has already happened.
Still, it's safe to say that the higher profile and soon-to-come change certainly won't hurt REITs, and could continue to help. Investors in SMI's Dynamic Asset Allocation strategy have already benefitted greatly from the inclusion of VNQ in their portfolios this year, and there's reason to believe the tailwind may continue as the index change becomes official in September.
Update 7/11: Josh Brown at The Reformed Broker has more detail on REITs and the upcoming shift in The best performing asset class no one talks about.