The Peccadillos of REIT investing in 2017

Real estate investment trusts (REITs) are an income-producing investment for many people but how much do you really know about them?

Even though REITs trade like stocks, their underlying structure and business model are very different. After all, what business than a REIT pays out 90% of its income as dividends every year? With uncertainty, market volatility and at least one interest rate increase ahead in 2017, being selective is going to matter now more than ever.

The National Association of Real Estate Investment Trusts (NAREIT), a trade group for the industry, lists 18 different categories and sub-categories of REITs. These include the big ones such as residential, commercial, industrial, etc., with their specialized sub-categories. But REITs also include niche sectors like health care, self-storage and timberland. Sixteen of these broad categories own and/or manage actual real estate. However, two invest primarily in mortgages.

A tiring REIT bull or the growing pains of a maturing industry?

REITs have a great decade thus far, outperforming every major equity and fixed income market index during the last five years. By March 2016, REITs were returning a solid 12.6%, including dividends, compared to the S&P’s roughly 7.8%. By mid-year, REITs still traded at a 7-10% premium to the value of their underlying assets. Skeptics in the industry have been arguing that REITs have become too expensive, especially when it looks like cheap borrowing soon may be at an end.

The market agrees. The REIT sector has broadly declined more than 5% in the last three months, with regional retail falling more than 10% in October alone. The sector has still returned about 7% year-to-date. However, three categories are now in negative territory for the year, according to a recent report by NAREIT. Five categories, on the other hand, are up double-digit percentages for the year.

Investment Performance by Property Sector and Subsector

A maturing industry

With the addition of Real Estate as an independent economic sector in the Global Industry Classification Standards (GICS) earlier in the year, the number of investments in the industry and active REITs in general have multiplied. The sector’s market cap has grown four-fold during the last 10 years to more than $1 trillion. This is akin to a stock being chosen as one of the S&P 500, with the resulting boost in coverage by analysts, media and institutional investors.

This is a momentous change, indeed. Real estate is being regarded as practically a separate asset class. As with all asset classes (such as equities/ fixed income/ commodities), the REIT sector also will become more nuanced over time. In point of fact, the bust in self-storage REITs this year (down more than 16% year to date) hasn’t weighed down or affected the positive double-digit percentage returns in hotel/lodging or timberland REITs.

I personally think the uneven performance over the last three months points to growing pains in a maturing REIT market. The massive influx of capital into the industry as a whole has been a major factor in its incredible performance over the last few years, helped largely by cheap borrowing. As the era of low rates comes to a gradual end, investors have realized that they need to become a lot more selective if they want to maintain the type of returns they are used to receiving. Sophisticated investors are already discerning cycles within the 18 categories of the sectors and weighting their portfolios accordingly, with REITs added and tracked as a separate investment sector by GICS. This trend will only grow in the coming years.

Being selective in choosing REITs will pay off for investors.

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Karn Brij is a Managing Director at an international investment firm with interests in real estate, banking & alternative investments. He specializes in real estate, finance & India-focused investments.