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REITs: Finally a Sector All Their Own. And That’s Good for Gains

What’s not to like about real estate investment trusts (REITs)? Created by Congress as a way for the average Joe to own commercial real estate, REITs, through their combination of high dividends and capital appreciation, have been one of the best total returning asset classes over the last few decades. Even when accounting for the issues during the Great Recession, REITs have been strong portfolio contenders.

Despite their growing popularity, commercial real estate and REITs have been the unseen heroes of the markets. That’s because they haven’t really been their own thing, at least not in the eyes of the big indexers.

But all of that is about to change. REITs and commercial real estate are coming into their own. For investors, the change is enough to help the sector push the market’s malaise to become big winners in the new year.

Changes to Indexing

Most indexing firms use a particular set of standards called the Global Industry Classifications Standard (GICS) to classify the type of business in which a firm operates. For example, the GICS sector designation is what designates a health care stock as a health care stock. The standards were created by Standard & Poor’s and MSCI Barra (MSCI) back in 1999.

Back then, real estate wasn’t exactly a widely known or followed asset class. REITs were in their infancy, having only been launched in 1994. As a result, the GICS system simply chucked them into the closest category at that time: financials. And there they’ve sat since then.

With hundreds of REITs and real estate operating companies now in the marketplace, S&P and MSCI have begun to tinker with the GICS designations. Real estate has become important enough to merit its own asset class under the system. By the time summer rolls around this year, REITs and real estate will be on their own.

When finally separated from financials, real estate will be the eighth-largest GICS sector, above both utilities and telecommunications firms.

Why Is the REIT Move Significant?

I know what you’re thinking. How does this affect me or my portfolio? After all, if I want to add exposure to REITs, I can just add something like the Vanguard REIT ETF (VNQ) or the Simon Property Group (SPG ).

That is true. The really significant moves will come from institutional investors.

Various pension funds, endowments, insurance pools and other institutional managers often use investment strategies based on MSCI and S&P indexes. Many of these investors include them in their mandates, thus the changes will directly affect how these portfolios are positioned.

In addition, broad equity index funds that use MSCI and S&P indexes represent around $5 trillion in invested assets. Those indexes are now underweight REITs when looking at them broken out. Today, they stand at about 2.3%, however, after real estate is its own GICS classification, that number will jump closer to 5%. That should cause north of $100 billion dollars to flow into REITs by the end of 2016 solely based on the index changes.

Further, the changes should remove much of the long-term volatility of the sector as new investment products are launched to take advantage of the changes.

Perhaps even better, REITs should continue to see more love from other money managers after the break out, thanks to the sector’s dividends. The newly separated real estate sector should have an average yield of 2.8% versus the financials yield of 1.9%.

Buy Some REITs

Ultimately, the move to separate REITs from the broader financial sector will only stand to benefit investors already owning REITs. More attention to the space will only serve to push up valuations as money managers bring their weightings up to the new index levels.

Investors today can get out ahead of the changes. Buying a vehicle like VNQ or the newly launched Real Estate Select Sector SPDR Fund (XLRE), which holds all the REITs/real estate firms in the uber-popular Financial Sector SPDR (XLF), makes a lot of sense. You should see a rise in share prices simply based on the flow of money into real estate now that it is its own asset class.

And you may want to stick around after the initial jump. Long term, REITs have done very well versus traditional stocks and bonds. Over the last 20 years, REITs have managed to score 11%+ annual returns. The new GICS designation will only help drive that outperformance even further.

All in all, you should be adding REITs to your portfolio.