Ever since the Global Industry Classification Standard (GICS) sector was established in 1999 to classify REITs, real estate REITs were lumped into the Financials Sector, along with banks, insurance, and other diversified financials.

Well that’s all changed. Effective September 1, real estate is now its own sector, the first new sector since GICS launched. As part of the change, the REIT industry will be renamed Equity REITs, although REITs will stay within the Financials Sector. Breaking REITs out into their own standalone sector creates the 11th separate GICS sector, and REITs will be the ninth-largest ahead of the materials, utilities, and telecom sectors.

Why the change?

The National Association of Real Estate Investment Trusts (NAREIT) took a very active leading role in this initiative. The organization spent a lot of time explaining to the community how REITs are a distinct asset class having the characteristics of both bonds and stocks. Like a bond, REITs offer a stable cash flow stream from dividends, but are similar to stocks because of the growth in cash flows they offer. This makes them different from other types of stocks within the Financials Sector.

Speaking of dividends, the yield offered by REITs is approximately 100 basis points above other Financials Sector stocks. Market cap size is another differentiator, as the collective market cap of all publicly traded REIT stocks exceeds $1 trillion, according to NAREIT.

Who will be affected?

The shareholder universe for REIT stocks is comprised of several groups. This includes a unique and select group of what we call dedicated REIT investors, who focus strictly on REIT stocks to the exclusion of other equity classes. There are collectively about 35 or so different firms that fall into the dedicated REIT investor category -- together, they hold anywhere from 20 percent to one-third of the shares of all publicly traded REIT shares and are a very influential investor group. Plus, with the creation of various index and exchange traded funds (ETFs), index investors also represent a sizable portion of the REIT shareholder base. The other group are generalist investors who follow multiple investment sectors. Generalists represent a smaller fraction of the REIT shareholder universe, but that may change with the GICS reclassification.

What will be the impact of REITs moving into their own GICS classification?

When REITs were part of the Financials Sector, investors didn’t need to specifically invest in REITs. Investors could invest in the stocks of banks or insurance companies, which were also part of the Financials Sector, as an alternative and remain benchmark neutral, meaning they’ve allocated enough dollars to other stocks within that sector without being underweight or overweight in that sector as a whole. In addition, REITs tend to screen as expensive on an earnings per share (EPS) basis compared to the valuations of other sector stocks because the primary financial performance metric for the REIT industry is funds from operations (FFO), which makes certain adjustments to reported GAAP net income, including the adding back of depreciation expense.

There are other financial and operating metrics that generalist investors are not as familiar with as a dedicated REIT investor would be. These include net asset value (NAV), recurring FFO, same store net operating income (SS NOI), and leasing spreads, to name a few. As a result, REITs have historically been underweight in Financials Sector portfolios by generalist investors. This creates a wonderful opportunity for the REIT industry, because generalists can no longer ignore REIT stocks -- they have to make a specific determination whether or not they’re going to invest in REITs. Over the last 15 years, REITs have been the best performing asset class, according to the Wall Street Journal. They’ve returned about 12 percent, which is far superior to any other asset classes during that span. If a generalist elects to remain underweight in their REIT holdings, it exposes them to market risk and makes them susceptible to possibly underperforming in the market. All of this should create a positive inflow of capital into REIT stocks. This is not expected to happen overnight, but over a gradual period of time as we further educate the generalist investors and they gain a greater understanding of our industry.

To recap, this new sector is a positive step that will help REITs gain greater visibility to the investment community, both in U.S. and international markets. It should result in REIT stocks attracting more capital from generalist investors and index funds. And when more capital comes in, that should improve the overall valuation of the industry. This is similar to what occurred when certain REIT stocks started being added as a component of the S&P 500.