Sometimes you don’t know what you’ve got until it’s gone. That may be the case today for investors in financial sector index funds. In August 2016, GICS®—the Global Industry Classification Standard for equities developed by Morgan Stanley Capital International (MSCI) and Standard & Poor’s—split off real estate securities from financials, creating a new sector for the first time since GICS was conceived in 1999. By mid-September, the mutual funds and exchange-traded funds (ETFs) that track these financial sector indexes had to either drop real estate securities altogether or transfer those holdings to index funds tracking the new sector. (See “What happened to my financial sector fund?” below.)
While some fund companies communicated the changes before they occurred, many investors are just now waking up to the reality that they might owe taxes on capital gains related to the shift in their funds’ holdings. Still others might be wondering whether they are underweight or overweight in financials or real estate stocks and need to rebalance.
At times like these, it’s important to understand not only what you own in your portfolio but whether it still fits your needs. Real estate stocks have very different risk-return profiles from financials, and the two sectors will likely diverge further in the months ahead as interest rates rise. So how does the new sector work—and what are the potential consequences for investors?
A look at the new sector
Nearly all of the new real estate sector is made up of equity real estate investment trusts, or REITs: companies that own physical property—apartments, malls, storage facilities and the like—and typically receive rental income. (Real estate management and brokerage companies make up the small remainder of the sector. So-called mortgage REITs, which purchase mortgages rather than physical property, remain in the financial sector.)
REITs are required to pay out a majority of their taxable income to shareholders in the form of dividends. As of late 2016, the average dividend yield of the S&P U.S. REIT Index was 4.17%, compared with 2.12% for the S&P 500® Index.1 Indeed, The Wall Street Journal reported last year that, without the benefit of REITs, the dividend yield of the financial sector could drop by about 20 basis points, from 2.28% to 2.08%.2
High dividend yields have helped REITs produce attractive returns in recent years, which prompted MCSI and Standard & Poor’s to consider adding the new sector. As of December 2016, the MSCI U.S. REIT Index, for instance, had returned 4.3% on an annualized basis over the past 10 years.3
REITs’ future prospects
The question now is whether that performance is sustainable. Equity REITs have provided attractive income streams of late, but it’s important to remember that, like all stocks, they are subject to volatility—as well as additional risks. Here are three major factors to keep an eye on:
1. Rising interest rates. If U.S. interest rates continue to inch higher over the next several years, real estate companies’ borrowing costs will rise with them, potentially reducing profit margins. Additionally, investors have turned to REITs to generate income in the current low-rate environment, but higher interest rates may prompt many to migrate back to traditional fixed income investments.
2. A changing rental market.
- Home. REITs may experience additional challenges if a significant number of renters transition to homeownership. The median rent in the U.S. has been steadily increasing for nearly a decade. If the price difference between rents and mortgage payments continues to shrink, more renters may become owners, potentially leaving behind an oversupply of rental apartments.
- Commercial. Declining sales at brick-and-mortar shops due to the rise of online shopping will likely lower the rents malls charge tenants, further undercutting equity REITs.
- Office. The demand for office space may decline if the trend toward working remotely continues.
3. The current U.S. economic expansion. Although an economic contraction isn’t yet on the horizon, all expansions eventually lead to a recession. Given the cyclical nature of commercial real estate, that could mean oversupplies of offices, malls, factories and other commercial properties many REITs rely on for income.
To be sure, we don’t believe rental markets are in danger of imminent collapse. For income-minded investors, maintaining the same amount of exposure that the S&P 500 allocates to equity REITs—about 3%—may make sense given their historically attractive dividend payouts. But we do expect the longer-term trends identified above to start solidifying over the next two years. Consequently, if the percentage of real estate holdings in your portfolio exceeds that 3% mark, it might be time to consider taking some profits.
Brad Sorensen, CFA®, is managing director of market and sector analysis at the Schwab Center for Financial Research.
1. S&P Dow Jones Indices, as of 11/30/2016.
2. Daisy Maxey, “When REITs Leave, Financial-Sector Funds Could Lose Some Yield,” The Wall Street Journal, 08/18/2016.
3. MSCI Inc., as of 12/16/2016.