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What ETF Investors Need to Know About the New Real Estate Sector

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Real estate investment trusts or REITs are set to enter a new era on Sep 1, soon after the S&P Dow Jones Indices and MSCI Inc., create the new Real Estate Sector under the Global Industry Classification Standard (GICS).
The new classification is a long due recognition for the REITs, which are currently part of the broader financials group. Starting Sep 1, the Real Estate Investment Trusts Industry will be renamed Equity Real Estate Investment Trusts (REITs). As the name suggests, they will exclude Mortgage REITs, which will remain under the broader financial group.
REITs are Preferred Investment Choices
REITs are an asset class that allows investors to buy into real estate without actually purchasing properties. Traditionally, REITs boast high dividend payouts, as they are required (per the U.S. laws) to distribute 90% of their annual taxable income in the form of dividends.
This feature makes REITs particularly attractive for dividend-loving investors. Moreover, REITs help diversify portfolios and lower risks as their correlation with market movements is relatively low.
Further, the persistently low interest rate regime is favorable for REITs as they can borrow at a lower rate, which can be used to buy real estate or develop properties. So far, the U.S. Federal Reserve’s dovish stance on rate increase has positively impacted REITs.
Improving U.S. Economy Drive REIT Returns
The U.S. economy continues to demonstrate signs of improvement as reflected by a solid job report and an enhanced level of economic activity. The month of July saw the addition of 255,000 jobs and the unemployment rate remained at 4.9%.
The job growth was well above the 180,000 rise projected by analysts. Though it was lower than the upwardly-revised June job addition of 292,000, the trend remained bullish. The measly 11,000 job growth in May was also positively updated to 24,000. (Read more: What Does the Solid July Job Data Mean for Bond ETFs?)
The positive data strengthens the industry’s fundamentals, which eventually builds demand for properties driving REITs. This is also evident from the data available from FactSet, which show that real estate funds have attracted a whopping $6.8 billion in fresh investor cash in 2016.
REIT Returns Crushing S&P 500, Financials
Year-to-date, REITs have performed markedly better than the S&P 500. The FTSE/NAREIT All REIT Index had a total return of 18.1% through the first seven months of 2016 (July-end) as compared to the S&P 500’s 7.7%. Notably, the yield on the 10-year Treasury note dropped 0.8% over the same period in 2016.
Moreover, when compared to the broader financials group, REITs are up almost 10% as compared with 0.3% returns from the financials. REITs, on a stand-alone basis, currently have a yield of 3%, way better than financials’ 2.06%.
However, an impending rate hike can derail growth. Minutes from the Federal Open Market Committee (FOMC) meeting in July shows that a rate hike might be in the cards in the remainder of 2016. (Read: ETF Winners and Losers Post Jackson Hole Meet)
Rising rates imply higher borrowing costs for REITs which impact their ability to purchase or develop real estate. Moreover, REIT stock yields lose luster when treasury yields rise.
Portfolio Rebalancing: REITs to Watch
Creation of equity REIT as a new sector – 11th in the S&P 500 cohort -- is bound to impact the portfolios that are linked to either an S&P 500 or an MSCI financials index. According to CNBC, “The REIT carve-out will take about a fifth of the value from financials and comprise about 3.1 percent of the total index, making it larger than the materials, telecom and utilities sectors.”
Hence, portfolios will need rebalancing to accommodate the new sector, keeping in mind the underlying exposure, income opportunities as well as tax implications.
We believe the transition opens up significant prospects for investors, considering the dividend income and capital appreciation possibilities. We deem ETFs to be the best investment vehicles to explore the sector.
Here we list a few REIT funds that are worth watching following the new classification: 
Vanguard REIT ETF (VNQ - Free Report)
The fund tracks MSCI US REIT Index and consists of 153 stocks. It charges 12 basis points (bps) in fees. VNQ has managed to attract $35.58 billion in assets under management (AUM) till August 23, 2016.
iShares U.S. Real Estate ETF (IYR - Free Report)
The fund tracks Dow Jones U.S. Real Estate Index and has a holding of 117 stocks. The fund charges 43 bps in fees. IYR has managed to draw $5.15 billion in AUM till August 23, 2016.
iShares Cohen & Steers REIT ETF (ICF - Free Report)
The fund tracks Cohen & Steers Realty Majors Index and has a holding of 31 stocks. The fund charges 35 bps in fees. ICF has managed to pull in $4.15 billion in AUM as of August 23, 2016.
SPDR Dow Jones REIT ETF (RWR - Free Report)
The fund tracks Dow Jones U.S. Select Real Estate Index and has comprises 100 stocks. The fund charges 25 bps in fees and has managed to fetch $3.91 billion in AUM till August 23, 2016.
Real Estate Select Sector SPDR Fund (XLRE - Free Report)
The fund tracks Real Estate Select Sector Index and holds 29 stocks. It charges 14 bps in fees.
Issuer State Street Global Advisors (SSGA) is set to pay a “special dividend” of XLRE shares to investors of its hugely popular $16 billion Financial Select Sector SPDR Fund (XLF). After the rebalancing is complete (mid-September), XLRE will become a $3 billion fund from its current (as of August 23, 2016) AUM of $113.5 million.
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