$100 Billion Tailwind Lifting Sails of This High-Yielding Group
Yes, you read that correctly.
Up to $100 billion may be flowing into this underinvested group due to an asset allocation sea change occurring Sept. 1. It’s a simple and profound shift that will highlight the newfound importance of this high-yield group.
It’s remained hidden within the general financial sector classification for years. But now, the two largest index fund creators in the world are effecting this monumental change (more on this in a minute).
The group garnering all the attention is real estate investment trusts, commonly referred to as REITs.
Like stocks, REITs are publicly traded on U.S. exchanges and are subject to the same accounting, reporting and regulations as any publicly traded company. Yet REITs aren’t really stocks. Rather, they are structured more like mutual funds, except instead of owning a portfolio of stocks and bonds, the bulk of their assets must be in real estate properties.
REITs generate revenue by leasing out the properties held in their portfolios and collecting rent from their tenants. The kind of property varies depending on the REIT, but it ranges from shopping centers to residential apartments, warehouses, office buildings, prisons, timber, even data storage solutions.
The key factor between them all is that they each generate income renting out the underlying physical assets. Essentially, REITs offer everyday investors the benefits of being a landlord with none of the day-to-day hassle.
And because real estate values tend to increase over time, REITs also offer long-term appreciation. This makes them even more appealing compared to other fixed-income investments.
The other structural aspect of REITs is that they must distribute at least 90% of their taxable income as dividends. This requirement translates into huge yields when compared to ordinary dividend-paying stocks, bonds and other so-called high-yield investments.
For a yield-starved investing public that gets virtually nothing from traditional income investments like Treasury bonds — thanks in large part to the Federal Reserve’s continued low interest rate policy — the allure of big yields is just too good to pass up. And the yields are truly impressive.
I looked at yields for over 220 REITs and came up with an average yield of 5.7%. Compare that to the S&P 500, which only offers a trailing yield of 2.1%, or even iShares Select Divided (NYSE: DVY) — a basket of top dividend stocks — which has a trailing yield of 3.2%, and it’s easy to see why REITs would be extremely attractive to investors.
That investor interest has propelled the sector higher. During the first six months of 2016, the MSCI US REIT Index, a proxy for the group, has posted a total return of 14.8% year to date, outperforming the S&P 500’s total return of just over 2.2% during the same period.
But investors aren’t the only ones taking an interest in this unique asset class. Two major index fund companies — S&P Dow Jones and MSCI — are reclassifying real estate as its own market segment. (The group is currently hidden away in the gigantic financial sector, which includes banks, investment brokers, insurance companies and asset managers.)
Starting Sept. 1, the S&P 500 will have 11 segments, rather than the current 10. The new real estate sector will comprise 3% of the S&P 500, which would make it similar in size to utilities, materials and telecommunications services.
While this change won’t matter much to index funds (which have always owned REITs), analysts believe it will have a big impact on actively managed mutual funds and hedge funds, which, as a group, are heavily underinvested in real estate.
For example, Goldman Sachs (NYSE: GS) recently found that 40% of large-cap mutual funds didn’t own a single REIT. That’s an enormous underinvestment, especially when you consider that REITs have been the market’s best-performing asset class over the past 15 years.
According to J.P. Morgan Asset Management, the group has returned an average return of 12% a year since 2000, significantly higher than the No. 2 performer (high-yield bonds, 7.9% average return) and nearly three times better than large-cap U.S. stocks (4.1% average return).
Breaking REITs out into their own sector will make it easy for investors to see exactly which funds are ignoring this impressive asset. With the spotlight shining directly on them, managers must buy their way out of the problem. David Kostin, the chief U.S. equity strategist at Goldman Sachs, recently estimated this predicament alone could spur $19 billion in demand in the new sector; other market experts believe fund managers could end up directing as much as $100 billion toward the sector.
But this isn’t the only good news out of this asset class. In early June, industry heavyweights converged in New York City for REITWeek, the pre-eminent conference for all things REIT. Among the key takeaways from this year’s conference were a few very positive trends.
First, business fundamentals have broad strength. There is growing demand, constrained supply and high occupancy rates. That should be a winning trifecta for REIT shares.
Second, REITs are firmly bidding for properties to add to their portfolios, which shows up in a metric called capitalization rate. The cap rate measures the rate of return on a real estate investment property based on the income analysts expect it to generate. After a rocky start at the beginning of the year, cap rates have improved, which explains the competitive bidding for properties.
Of course, no asset class is perfect; just like stocks, bonds and funds, REITs have their own set of problems. For example, economic slowdowns — like what we saw at the beginning of the year — can result in increased vacancies, which effectively drains cash flow. But since recovering from their stumble earlier in the year, the group is showing no signs of problems.
In fact, while the rest of the market was reeling from the aftermath of the Brexit vote, my top REIT pick was surging to new highs.
It owns more than 1,000 single-tenant commercial real estate properties across 46 states under long-term net leases. Net commercial leases require the tenant to pay rent as well as other expenses like taxes, insurance, maintenance, repairs and utilities.
It is broadly diversified. Its commercial property portfolio includes supermarkets, restaurants, drug stores, service and distribution facilities. This diversification can help smooth out rough spots from downturns in any one sector.
Instead of using standard earnings and revenue measures for REITs, analysts prefer a fundamental metric called “funds from operations” (FFO). FFO for REITs is a measure of cash flow, and it’s quoted on a per-share basis. My top REIT grew its adjusted FFO over 41% in Q1.
Technically, it is in a 10-month uptrend and just broke out strongly from a rising wedge formation on large volume.
But what has this REIT at the top of my list is a confidential indicator that only a handful of traders have access to. This powerful tool delivered 83% gains in 28 days. If you’d like to learn more about it — and find out how to get my top picks based on it, including my favorite REIT — follow this link.