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REITs—Still Evolving

The “modern REIT era” dates back to legislation passed in 1960. In the last half century, the sector has evolved from being a small unloved (deservedly at times), misunderstood and volatile investment alternative into an almost-mainstream category. In recognizing their growing importance, S&P Dow Jones Indices and MSCI, the two most widely used index providers, created a new real estate investment trusts category in September 2016. Calved off from financials, they created a new stock sector for the first time since 1999 when the original 10 sectors were designated.

This is a pretty big deal. One of the most widely reported indicators of stock market trends is the return of the now-11 major sectors. The Wall Street Journal noted: “With a stock market capitalization approaching $600 billion, S&P 500 REITs have eclipsed the telecommunications and materials sectors’ and are approaching that of the utility sector.”

I have been a REIT enthusiast since the late 1990s when they were an orphan category and ignored during the tech mania−on average, they were selling at 20% discounts to the net asset value (NAV) of their underlying holdings and yielding around 8%. I have been managing a REIT strategy since 2003.

Diversified stock funds have typically owned only about one-half of the S&P 500’s REIT weighting, so long-term, I expect the creation of a REIT S&P sector should add to demand for REITs.

But there are other reasons why REITs are likely to continue to grow in the coming years. Publicly traded REITs represent only 15% to 20% of all commercial real estate and that percentage is almost certain to continue growing.

Stock prices are hovering near recent highs and since the stock market discounts the future of the economy and corporate earnings, looking at expectations is helpful: a recent Fact Set poll of analyst expectations reports that analysts are forecasting earnings growth of 12.5% for 2017.

Maybe, maybe not. John Kenneth Galbraith said of economists, “There are those that don’t know and those that don’t know they don’t know.” Wall Street analysts’ forecasts are not too dissimilar. However, experience shows that expectations often change dramatically, and that poses a risk for stock prices. While you can’t hang your hat on forecasts, real estate results are somewhat more predictable because a significant percentage of commercial real estate is secured by multi-year leases. So they are worth a look. Lazard Global Real Estate Securities forecasts REITs growth of 3.5% in 2017 and 3.2% in 2018 [which] “translates into 5% to 7% earnings and dividend growth…”

While the market’s obsession with REITs’ vulnerability to rising interest rates continues unabated, a number of studies in recent years showed that interest rate risk is overblown, barring sudden sharp increases over a short period of time. In a September 2016 conference call, Steve Buller, portfolio manager of Fidelity Advisor Global Real Estate Fund, cited internal Fidelity historical studies that drew the same conclusion.

Some investors are concerned about the shrinkage in the number of malls as online shopping continues to cripple retail stores. But only a small percentage of the REIT universe is involved in retail.

A more serious hazard, in my opinion, would be a recession that would negatively affect not only commercial real estate and REITs, but also stock prices in general. If we could accurately predict when that will occur, all our worries would be over.

Whatever the future holds, REITs should be part of almost all investment portfolios.

—Jerrold Tweddell

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