The desire to own a place of your own is powerful. And as of this month, property shares no longer have to put up with roommates or landlords. Property-related shares now have their own sector within the indices constructed by MSCI and S&P. Previously they dossed in the financial sector’s spare bedroom. The new accommodations may have increased valuations already stretched by yield-chasing — but real estate is no simple play on low rates.
The new sector contains developers and management groups but is mostly made up of real estate investment trusts, or Reits. These have been big beneficiaries of low interest rates, which have both cheapened the debt that is integral to property funding and prompted an investor stampede into income-generating assets. Reits are required to pay out 90 per cent of taxable income as dividends and the sector’s average 4 per cent yield has pulled in the punters. Over the past two years, FTSE’s NAREIT index beat the S&P 500 by 12 per cent on a total return basis. Reits make up 3 per cent of the S&P 500 — similar to materials or telecoms.
Their popularity has made the sector expensive. As a multiple of “funds from operations” — a tailored metric defined as net income before depreciation and profits from asset disposals — shares are trading at historically high levels. But Reits are not just another asset class pumped up by cheap money. Research by Morgan Stanley suggests that the shape of the yield curve is more important for future performance than the absolute level of interest rates. A higher short end allows for rent increases. A lower long end reduces the discount rate applied to future cash flows, making them worth more in today’s money.
Reits remain a complex asset class but the more widespread visibility afforded by a dedicated real estate sector is welcome. Their idiosyncrasies could yet provide useful options for interest rate-sensitive equity investors.
Email the Lex team at email@example.com