Lazard Insights Real Estate: A New Sector in Global Benchmarks Christopher Hartung, Director, Portfolio Manager/Analyst Summary On 31 August 216, real estate will be the first new sector to be added to the GICS since the system was formed in 1999. We believe the change is rooted in real estate s proven differentiated investment attributes which include strong risk-adjusted returns, diversification, stable earnings, and yield. While investors should consider the real estate cycle, valuations, and the potential for an interest rate correction upward, we believe the current environment is favorable for continued strong relative performance of the asset class. Lazard Insights is an ongoing series designed to share valueadded insights from Lazard s thought leaders around the world and is not specific to any Lazard product or service. This paper is published in conjunction with a presentation featuring the author. The original recording can be accessed via www.lazardnet.com/insights. Introduction While not as noisy or messy as the arrival of the seventeen-year cicada, or as rare as Halley s Comet passing the earth, the upcoming Global Industry Classification Standard (GICS) change (i.e., the inclusion of real estate as a stand-alone sector) is an important next step for the real estate industry and will likely have a meaningful impact on diversified investors portfolios. In this paper, we discuss the specific changes to GICS, the potential impact it may have on the real estate industry, and will also evaluate the benefits of a real estate allocation. What Is the Significance of the GICS Change? On 31 August 216, real estate will be the first new sector to be added to the GICS since the system was formed in 1999. MSCI and Standard & Poor s developed the GICS, the basis for their indices, to classify securities and companies into industry groups. The addition of real estate, which previously fell under the financials sector, will be reflected in all the MSCI and S&P indices upon the annual index rebalancing on 16 September 216.
2 Exhibit 1 Real Estate Will Become GICS s Ninth-Largest Sector Globally Share of Total Market italization (%) 24 Global 16 8 Information Technology Consumer Discretionary Financials Industrials Consumer Staples Health Care Materials Energy Real Estate Telecom Services Utilities As of 11 August 216 Source: Bloomberg The shift is significant. Real estate will become the ninth-largest sector, ahead of telecom services and utilities, and will make up just over 5% of the global total market cap (Exhibit 1). Within the United States, real estate moves ahead of materials into eighth place. Moreover, these calculations are based on the broad market, so for some segments of the market such as mid-cap or small-cap indices, real estate will take on more prominence. It is also worth noting that both REITs and real estate operating companies (REOCs) will make up the new sector while mortgage REITs will remain within the financials sector. Based on industry estimates, anywhere from $3 to $1 billion of new capital may flow into REITs as a result of this change. We do not disagree with this broad estimate, and in fact, we have likely already seen capital flow into the asset class (based on the reduction in equity fund underweighting to real estate). While this is a less quantitative view, we believe the change will have more of a long-term impact. Institutional investors have long viewed real estate as a distinct asset class and those that have chosen to invest in the asset class, on average, have allocated nearly 1% to it. As real estate garners higher awareness and visibility, we believe more investors will allocate or increase their allocations to the asset class. In turn, a broader investor base can lead to more stable performance and support for valuation levels. While these estimates may come to fruition, it is a bit of a red herring. In our view, the real story is why the change is happening in the first place. The best place to start is the source. The Global Head of Research for MSCI, Remy Briand, has argued that This is the first significant structural change to GICS sectors since its inception and reflects the position of real estate as a distinct asset class and a foundational building block of a modern portfolio, rather than an alternative. We believe this statement is verified by real estate s unique investment characteristics of differentiated performance, diversification, earnings stability, and yield/inflation protection. Since this idea of differentiated performance is really the crux of where we think investors should focus, we will address whether those unique attributes hold true. Differentiated Performance Differentiated performance is one of the primary reasons to own real estate. REITs have proven to be a thoroughbred asset class, as it has outperformed stocks and bonds over 3-, 5-, 2-, 3-, and 4-year periods (Exhibit 2). However, these comparisons are based on index or benchmark performance and therefore do not account for actualized (i.e., after fees) returns which, at the end of the day, is what matters. A recent study by CEM Benchmarking 1 looked at actualized investment returns for defined benefit pension funds in the United States from 1998 214. Exhibit 2 REITs Have Outperformed Stocks and over Several Decades Compound Annual Returns (%) REITs NASDAQ S&P 5 Index Russell 2 Index Corp./ Govt. High Yield 3-Year 13.31 12.48 11.66 7.9 4.37 4.18 5-Year 12.52 11.79 12.1 8.35 4.19 5.84 1-Year 7.45 8.35 7.42 6.2 5.26 7.56 2-Year 11.23 7.29 7.87 7.61 5.76 7.3 3-Year 1.56 8.62 9.82 8.54 6.64 8.15 4-Year 13.49 1.47 11. 7.66 As of 3 June 216 Shaded numbers indicate top-performing asset class. REITs = FTSE NAREIT All Equity REITs Index; Corp./Govt. = BofA Merrill Lynch Corporate & Government Index; High Yield = BofA Merrill Lynch High Yield Index. The performance quoted represents past performance. Past performance is not a reliable indicator of future results. This information is for illustrative purposes only and does not represent any product or strategy managed by Lazard. It is not possible to invest directly in an index. Source: NAREIT
3 Exhibit 3 REITs Have Impressive Risk-Adjusted Returns Asset Class Net Returns, 1998 214 (%) Sharpe Ratio, 1998 214 12.8 8.6.4 4.2 REITs Private Equity Small Long Large Unlisted Real Estate Broad Fixed Income Hedge Funds/ TAA. Broad Fixed Income Long REITs Small Private Equity Large Unlisted Real Estate Hedge Funds/ TAA Data and asset class definitions are based on CEM Benchmarking s database of defined benefit pension funds. The performance quoted represents past performance. Past performance is not a reliable indicator of future results. This information is for illustrative purposes only and does not represent any product or strategy managed by Lazard. Source: CEM Benchmarking Even after accounting for fees, the study found that REITs have historically had the highest net returns of any asset class. In addition, when adjusted for risk (volatility) REITs fall short of fixed income options, but had the highest Sharpe Ratio of any equity group (Exhibit 3). Diversification REITs have demonstrated low correlations to other asset classes, such as stocks, bonds, and hedge funds (Exhibit 4). We believe the high correlation with unlisted (private) real estate makes sense since REITs have trended toward trading near their underlying net asset values over time. However, the holding period is critical to attaining this correlation, which should be the case since real estate in not meant to be a short-term investment. Earnings Stability In today s ever-changing and uncertain global economic environment, the stability of property-level cash flows is appealing. In particular, commercial real estate cash flow stability is not only supported by contractual leases with term agreements, but also by population and economic growth. This stability, which can break down at an individual asset level due to unique issues at a certain property, is supported by the large portfolios owned by public companies, which further reduce risk. Even in a period like the global financial crisis, occupancy levels among major sector REIT portfolios only declined by 4.7% (Exhibit 5). While the crisis led to year-over-year declines in property net operating income (NOI), property level NOI did not decline by more than 3% during any single year. Moreover, REITs have delivered positive property-level cash flow growth in seventeen of the last twenty-one years. If one had focused exclusively on the headlines during the global financial crisis, the impression would have been that every property was cash flow negative and most buildings were vacant. Currently, due to slow and steady economic growth combined with still-low levels of new supply across most real estate sectors, we believe the real estate asset class is looking at a decade of positive property-level growth for the public companies (Exhibit 6, page 4). Exhibit 4 REITs Have Low Correlation to Other Core Asset Classes Correlation with REITs, 1998 214 1..75.5.25. Unlisted Real Estate Small Large Private Equity Hedge Funds/ TAA Broad Fixed Income -.7 Long Data and asset class definitions are based on CEM Benchmarking s database of defined benefit pension funds. The performance quoted represents past performance. Past performance is not a reliable indicator of future results. This information is for illustrative purposes only and does not represent any product or strategy managed by Lazard. Source: CEM Benchmarking Exhibit 5 REIT Occupancy Levels Are Stable Major Sectors Average Occupancy (%) 95 9 85 2 Tech Bubble -3.5% 24 Financial Crisis -4.7% 28 As of 3 June 216 Data are based on the stocks covered by the NAREIT universe. Source: Lazard, NAREIT 212 216
4 Exhibit 6 Property-Level NOI Growth Has Remained Strong after the Global Financial Crisis Same-Store Property NOI Growth Exhibit 7 REIT Income Returns Have Exceeded Inflation since 1991 (%) (%) 2. 9 (%) 6 Index, 1994=1 25 1.5 8 4 2 2 15 1. 7 1.5 6-2 Growth per Year [LHS] Cumulative Growth [RHS] -4 1995 2 25 Inflation Protection 21 215 Real estate assets have historically protected against inflation. This is due to lease structures which call for rent increases based on CPI (a measure of inflation), general increased demand for real estate in times of economic growth (which is often accompanied by inflation), and because much of the cost of a property is in physical, commodity goods (which are inflationary in nature). In every quarter since the start of the modern REIT era in 1991, quarterly REIT income returns have exceeded inflation (Exhibit 7). The spread has narrowed somewhat over the past twenty-five years, but much of this can be accredited to lower dividend payout ratios among REITs. Regardless, even in recent years, quarterly REIT income returns have averaged 6 basis points (bps) more than CPI. Another way to look at it is to compare annual REIT dividend growth to CPI. Since 21, REIT dividend growth outpaced inflation in all years except for 28 and 29, when REITs cut dividend payments to reserve cash in an uncertain environment (Exhibit 8). Once that risk passed, REITs dramatically reinstated dividends which accounts for the huge dividend growth in 21. Considerations for a Real Estate Allocation 22E As of 3 June 216 Data are based on the universe of stocks covered by Green Street Advisors. Forecasted or estimated results do not represent a promise or guarantee of future results and are subject to change. Source: Green Street Advisors, Lazard We believe the data presented thus far supports the addition of real estate as its own GICS sector. As with any investment story, timing can be everything. Therefore, it is important to consider today s environment before a new, or increased, allocation to the asset class. There are three broad items that merit consideration: 1) The real estate 5. 1992 1996 2 24 28 212 NAREIT Income Returns minus CPI [LHS] Sub-Period Averages for Income Returns minus CPI [LHS] 1991 2 21 28 29 June 216 Dividend Payout Ratio [RHS] 5 216 As of 3 June 216 Data are based on the FTSE NAREIT All Equity REITs Index. The performance quoted represents past performance. Past performance is not a reliable indicator of future results. This information is for illustrative purposes only and does not represent any product or strategy managed by Lazard. It is not possible to invest directly in an index. Source: Bloomberg, Lazard, NAREIT Exhibit 8 Since 21, REIT Dividend Growth Has Exceeded Inflation in Every Year Except 28 and 29 (%) 64 32-32 21 REIT Dividend Growth 22 23 24 25 26 CPI 27 As of 3 June 216 Data are based on the FTSE NAREIT All Equity REITs Index. Forecasted or estimated results do not represent a promise or guarantee of future results and are subject to change. Source: Bloomberg, Lazard, NAREIT 28 cycle is long in the tooth so it is late to the game, 2) valuations are full, and 3) once monetary and fiscal-policy influenced compression of interest rates runs its course, capitalization rates snap upwards and real estate prices could fall. On the first consideration, it is interesting how much real estate is cyclical is a mantra among real estate professionals. Certainly there is a cyclical component to the asset class as there are economic, demo- 29 21 211 212 213 214 215
5 graphic, and supply cycles. However, no cycle is the same, and no one knows when the current run will end. Anecdotally, we have already heard accounts of property managers overcompensating to the headlines by reducing rents only to find increased demand. If we look at the stamina of real estate to produce positive returns over time, the past two cycles have been over fifty quarters in length. While it may seem long, given what we went through during the financial crisis, the current real estate cycle is just over twenty quarters long (Exhibit 9). While not a guarantee by any stretch, the duration of this cycle is less than half of the prior two cycles. From a valuation perspective, there are concerns about the elevated prices for core, downtown properties. While this may be the case, these properties only represent part of the market. This dynamic is evident in looking at the comparison between the NCREIF Total Return Index 2 (a measure of primarily core, institutional real estate) and two other price only measures (Exhibit 1). In addition, when only considering the total return indices, the heavy current income component of real estate obscures what is happening at the property level. Core pricing is more elevated than total commercial real estate, but not dramatically. In public markets, even with the strong price performance of REITs, the strong earnings growth (which is driven by growth in property-level cash flows) has kept earnings multiples in line with trading ranges since 21. Finally, the prospect of higher interest rates has been a concern around real estate since then-chairman Ben Bernanke floated the taper tantrum in late spring 213. That, combined with investors desire for real estate due to its current yield, has created a conventional wisdom that if interest rates increase, real estate will be hurt. Some of this may be true, but in the interim while waiting for rates to increase, investors have missed a 16% year-to-date (through July 216) return in REITs and positive returns, if this year holds, in seven of the last eight years. The reason behind this is that real estate performance is affected more by the internal rate of return (IRR) than interest rates. Therefore, exclusively focusing on interest rates negates the growth aspect of real estate investments. Moreover, real estate s response to interest rates is contextual. One needs to appreciate the economic environment in which the rising rates occur. Sometimes it can be detrimental to real estate values, but oftentimes it accelerates values. Exhibit 9 The Current Real Estate Cycle Is Less than Half as Long as the Previous Two NCREIF Quarterly Returns (%) 9. 4.5. -4.5-9. 198 51 Quarters 56 Quarters 1984 1988 1992 1996 2 24 28 22+ Quarters 212 216 As of 3 June 216 Data runs from 31 March 1978 3 June 216 The performance quoted represents past performance. Past performance is not a reliable indicator of future results. This information is for illustrative purposes only and does not represent any product or strategy managed by Lazard. It is not possible to invest directly in an index. Source: Bloomberg Exhibit 1 Core, Institutional Real Estate Returns Do Not Reflect the Entire Market Index, December 2=1 4 3 2 1 2 23 26 29 NCREIF Total Return Baseline Commercial Real Estate Price Index Green Street Advisors Major Sectors Price Index 212 215 As of 3 June 216 The performance quoted represents past performance. Past performance is not a reliable indicator of future results. This information is for illustrative purposes only and does not represent any product or strategy managed by Lazard. It is not possible to invest directly in an index. Source: Bloomberg, SNL Financial, S&P Global Intelligence Conclusion While there is uncertainty about how equity managers and ETFs will approach real estate s addition as a new GICS sector, one thing for certain is that REITs will garner more attention. We have long held that REITs are a distinct asset class, based on their unique investment characteristics. REITs offer a differentiated source of returns (income backed by contractual leases) resulting in significant yield, enhanced diversification, and a historical hedge against inflation. While most institutional investors share this belief, others have invested in REITs only tactically or not at all. Over the long term, we believe the designation of real estate securities as their own GICS sector will lead to a greater adoption of the asset class.
6 This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm. Notes 1 Beath, Alexander and Chris Flynn. Asset Allocation and Fund Performance of Defined Benefit Pension Funds in the United States, 1998 214. CEM Benchmarking, June 216. 2 The NCREIF Index covers private real estate (direct investments in properties) rather than publicly listed REITs. Important Information Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one s home market. The values of these securities may be affected by changes in currency rates, application of a country s specific tax laws, changes in government administration, and economic and monetary policy. Emerging markets securities carry special risks, such as less developed or less efficient trading markets, a lack of company information, and differing auditing and legal standards. The securities markets of emerging markets countries can be extremely volatile; performance can also be influenced by political, social, and economic factors affecting companies in these countries. The performance of investments in real estate and real estate related securities may be determined to a great extent by the current status of the real estate industry in general, or by other factors (such as interest rates and the availability of loan capital) that may affect the real estate industry, even if other industries would not be so affected. The risks related to investments in realty companies include, but are not limited to: adverse changes in general economic and local market conditions; adverse developments in employment; changes in supply or demand for similar or competing properties; unfavorable changes in applicable taxes, governmental regulations, and interest rates; operating or development expenses; and lack of available financing. An investment in REITs may be affected or lost due in part to the fluctuation with the value of the underlying properties of the investment. An investment in REITs may be affected or lost if the REIT fails to comply with applicable laws and regulations, including tax regulations, specifically, the failure to qualify as a REIT under the Internal Revenue Code of 1986, as amended. Published on 21 August 217. This document reflects the views of Lazard Asset Management LLC or its affiliates ( Lazard ) based upon information believed to be reliable as of 19 August 216. There is no guarantee that any forecast or opinion will be realized. This document is provided by Lazard Asset Management LLC or its affiliates ( Lazard ) for informational purposes only. Nothing herein constitutes investment advice or a recommendation relating to any security, commodity, derivative, investment management service or investment product. Investments in securities, derivatives and commodities involve risk, will fluctuate in price, and may result in losses. Certain assets held in Lazard s investment portfolios, in particular alternative investment portfolios, can involve high degrees of risk and volatility when compared to other assets. Similarly, certain assets held in Lazard s investment portfolios may trade in less liquid or efficient markets, which can affect investment performance. Past performance does not guarantee future results. The views expressed herein are subject to change, and may differ from the views of other Lazard investment professionals. This document is intended only for persons residing in jurisdictions where its distribution or availability is consistent with local laws and Lazard s local regulatory authorizations. Please visit www.lazardassetmanagement.com/globaldisclosure for the specific Lazard entities that have issued this document and the scope of their authorized activities. RD199