When Standard & Poor’s and MSCI announced in March that real estate would be moving out of S&P’s financial sector to become its own standalone sector in September, performance expectations rose for the sector but fell for financials. 

Months before the change took effect under the Global Industry Classification Standard (GICS) system, the S&P Real Estate Select Sector SPDR ETF (XLRE) charged ahead of the S&P Financial Select Sector SPDR (XLF), but then, just as the change was being implemented, that performance reversed in mid-September. 

Real estate is now the worst performing S&P 500 stock sector for the past 13 weeks through December 2, down 11.3%, and it’s the second worst performing sector year-to-date after health care, down 4.1%. There are 11 sectors in the S&P 500 and its real estate sector is comprised primarily of Real Estate Investment Trusts (REITs).XLRE-Financials_Stock_Compare

Behind the sharp drop in the real estate sector are rising interest rates. Since July 8 the 10-year Treasury yield has surged more than 100 points, from 1.38% to 2.46% on Friday.

As rates rise the borrowing costs rates for REITs increase, which impacts profitability.

Rising rates also make REITs less attractive to investors because as a dividend-yielding investment (by law they have to return at least 90% of their taxable income to investors every year) REITs face increased competition from other income-producing investments paying higher yields.

“Rising interest rates are the number one reason REITs have underperformed since late summer,” said Jeff Kolitch, portfolio manager of Baron Real Estate Fund (BREFX), which invests in many real estate categories, not just REITs.

But rising rates do not necessarily doom all REITs or other real estate investments especially if rates are rising because of a fast-growing economy.

Rental housing REITs, for example, can benefit from faster growth by raising their rents; hotel REITs similarly can raise their room rates

In addition, gaming-related companies with embedded real estate, like MGM, and real estate related companies involved in home improvement such as Sherwin Williams, could do well, says Kolitch. His fund owns both stocks.

Gregg Fisher, the Chief Investment Officer of Gerstein Fisher and manager of its Multi-Factor Global Real Estate Fund (GFMRX), prefers a global approach with assets split roughly 50/50 between U.S. and foreign-listed REITs to “provide more diversification in terms of exposure to different economies, currencies, interest rate and inflation regimes.”

Rather than target specific sector like hotels, his fund “tilts toward specific factors such as value and momentum and away from leverage.” The five-star fund ranks in the top 5% of Morningstar global restate category.

“The death of real estate has been predicted for some years now but we still have divergent central bank monetary policy,” says Alex Lucas, a mutual fund analyst at Morningstar. “Others [i.e., foreign investors] think our relatively low yields are attractive. It may not necessarily be the case that rates will rise for sure.”

Case in point, according to Lucas, is what happened in 2014 after they spiked during the May 2013 “taper tantrum” following then Fed Chairman Ben Bernanke’s suggestion that the Fed might slow its asset purchases. “Rates shot up above 3% and everyone expected real estate to underperform. .. But to everyone’s surprise real estate did incredibly well because rates eventually fell,” said Lucas.

He suggests that financial advisors educate their clients about the different impacts of rising rates on real estate. “If there is a sudden spike in real estate, real estate holdings will not do well but if there is a steady rise, hotel REITs could do just fine. … And if we go through a long period of time where rates are rising then it’s likely the case that real estate management development companies  like CBRE [which is included in XLRE index] will become a bigger part of the market.”

Dave Mazza, head of research at State Street Global Advisors, suggests that investors “tactically reduce” exposure to real estate but not eliminate it from portfolios. “Real estate is a real asset and REITs are the equity on top of that. When prices are going up many REITs can charge higher rents.” He also notes that REITs which have locked in long-term commercial leases are usually less vulnerable to rising rates.

Even if rates rise, real estate may not be the worst performing sector, according to Sam Stovall, chief investment strategist at CFRA, which acquired S&P Global Market Intelligence’s Equity and Fund Research business in September.

During months of rising 10-year yields from early 1970 through December 7, 2016, the real estate sector had a positive average monthly returns, and though it was below 1% it outperformed consumer staples, financials, telecom services and utilities, the ultimate interest-rate sensitive sector.

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