Jun 14, 2016 - Remodeling REITs: A new sector for Real Estate Investment Trusts (REITs) is being created in the Global Industry ... many investment funds reflect, to one degree or another, this standard .... ML US HY Corp Master. 7.24. 0.9.
CIO REPORTS
The Weekly Letter JUNE 14, 2016
Chief Investment Office
Remodeling REITs: A new sector for Real Estate Investment Trusts (REITs) is being created in the Global Industry Classification Standard (GICS) on which many investment funds base portfolio weightings. We are taking a closer look at opportunities that this coming change may present for investors along with the traditional advantages of and concerns with the asset class, and areas of interest in today’s market.
Emmanuel D. Hatzakis
Markets in Review: Last week equities declined, with the S&P 500 index down 0.1%, while international equities, as represented by the MSCI EAFE Index were 1.7% lower. Bonds rallied on the week, with the 10-year Treasury yield ending at 1.64%, down from 1.70% in the prior week. Commodity prices as measured by the Bloomberg Commodity Index rose 2.1%, as WTI crude oil climbed 0.9%, to $49. 07, and gold gained 2.4%, to $1,273.92 per ounce.
Recent Publications
Director
Jon Lieberkind Vice President
Weekly Letter Home on the Range Infrastructure Impulse Europe Corporate Easing The Long and Short of Japan
Looking Ahead: In the U.S., the National Association of Home Builders (NAHB) housing index is expected to slip, and housing starts to decline. Eurozone Consumer Price Inflation (CPI) is expected to rise to 0.3% month-over-month (MoM) and remain unchanged at 0.8% year-over-year (YoY).
Remodeling REITs
Monthly Letter Investing in a Range-Bound Market CIO Outlook The Forces Shaping Our World
already see portfolio managers making some adjustments to their holdings to reflect the new grouping.
In our April 5 Weekly Letter, REITs Enter Adolescence, we wrote about Real Estate Investment Trusts (REITs) and their place among equity and fixed income allocations in investor portfolios. We are taking another look to examine opportunities and issues that might arise as a result of a change to the Global Industry Classification Standard (GICS) that takes effect after the market close on August 31st. The industry weightings for many investment funds reflect, to one degree or another, this standard classification. Most REITs are being removed from the Financials and established as their own sector, adding an 11th top-level category. As this event is approaching, we
A brief refresher on REITs1 REITs are organizations engaged in real estate investing. Equity REITs own and typically operate income-producing real estate properties. Mortgage REITs do not directly own assets but lend to owners of real estate. There are a few hybrids — equity and mortgage REITs. Exhibit 1 shows a breakdown of REITs by type. In the GICS realignment, Mortgage REITs will remain within Financials while the rest will form their own sector. The legal structure of REITs makes them attractive to incomeoriented investors. The entities must distribute 90% of their taxable net income to shareholders, and do not pay corporate
Exhibit 1: Breakdown of REITs by type (market cap in billions and % of total market cap)
n Equity REIT n Mortgage REIT $106.0 11.8%
Apartments
$62.6 7.0%
$106.0 11.8%
Regional Malls
$50.3 5.6%
$85.0 9.5% $81.2 9.1%
Health Care
Office
Self-Storage Mortgage
$45.0 5.0%
Industrial
$41.3 4.6%
Diversified
$71.8 8.0%
Infrastructure
$40.6 4.5%
Lodging Resorts
$68.8 7.7%
Shopping Centers
$40.2 4.5%
Data Centers
$30.0 3.3%
Free Standing
$26.0 2.9%
Specialty
$24.7 2.8%
Timber
$10.1 1.1% Manufactured Homes $6.2 0.7% Single Family Homes $896.0 100.0% Total
Source: NAREIT, BofAML Global Research and Merrill Lynch Chief Investment Office. Market capitalization of the FTSE NAREIT All Equity REITs Index and its subsectors, and of the FTSE NAREIT Mortgage REITs Index is shown as of February 29, 2016. Totals may be off due to rounding. Past performance is no guarantee of future results. 1
For a more comprehensive treatment: BofAML Global Research. May 2, 2016. “U.S. REITs Primer. 7th Edition: a comprehensive handbook for a new GICS sector.” Merrill Lynch Wealth Management makes available products and services offered by Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S), a registered broker-dealer and member SIPC, and other subsidiaries of Bank of America Corporation (BofA Corp.). Investment products: Are Not FDIC Insured
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May Lose Value
Managers are currently underweight REITs in their portfolios, as they are in Telecoms and Utilities, two sectors with similar characteristics, although in aggregate the REIT underweights are larger. This raises the risk that they won’t match their benchmarks, and with the realignment we expect them to respond by buying more REITs, especially for portfolios with constraints on sector tilts. BofA Merrill Lynch (BofAML) Global Research2 has estimated that managers’ purchases of REITs intended to reduce the underweights could bring inflows of $30 billion across small-, medium- and large-cap REITs. Investment firm Cohen & Steers3 goes even further to estimate a potential $100 billion of inflows if funds bring their REIT holdings in line with index weightings that reflect the new sector classifications. Foreign buying should contribute to the inflows since the recently passed Foreign Investment in Real Property Tax Act (FIRPTA) could increase overseas investors’ holdings in U.S. commercial real estate. Some of these inflows are already happening, as investors respond to the GICS realignment. With the low market liquidity typically observed over summer months, these inflows could exert more upward pressure on prices than they normally would. Another potentially positive effect of the new standalone REIT sector is that it should offer managers an opportunity to reduce the volatility of their funds to the extent that they add REITs and cut back on Financials, since Financials is one of the most volatile sectors.
Opportunities and potential issues Compared to other yield-focused sectors, REITs offer distributions that are higher than typical stock dividends along with favorable growth potential for the payouts. Coupled with their attractive long-term rates of return, these attributes could make them appealing to yield-seekers and to a potentially larger investor base. The heightened visibility brought about by the reclassification could prompt REIT managers to seek economies of scale and benefits from geographic diversification, resulting in consolidation through M&A or privatization. In anticipation of that, fund managers fearful of missing the deal wave could bid up prices. In a portfolio context, REITs can offer significant diversification benefits. They can provide exposure to real estate, an asset class whose returns have not been highly correlated with 2 3
A potential issue, which might explain the current underweighting, is that REITs are poorly understood by traditional fund managers. When using common valuation metrics, such as price-to-earnings ratios, REITs do not do well on value screens. They may also rank poorly in growth screens due to their low long-term growth rates compared to other sectors. This gives an edge to active managers specializing in REITs, who tend to be proficient in the earnings and valuation metrics used in the sector.
Subsectors differ in approach Among the REIT sub-sectors, Apartments and Data Centers enjoy strong fundamentals. Self-storage could also benefit from the housing preferences of Millennials, and the aging of Baby Boomers could be a boost for Health Care in the long term. Outside the U.S., we expect opportunities to arise in Europe and Japan, where central bank policies should eventually support economic growth and real estate valuations. Exhibit 2: REITs are a relatively attractive home for yield 10
REIT dividend yield less 10yr Treasury yield
8 6 4 Long-term average is 1.4%
2 0 -2
Oct −06 Mar −07 Aug −07 Jan −08 Jun −08 Nov −08 Apr −09 Sep −09 Feb −10 Jul −10 Dec −10 May −11 Oct −11 Mar −12 Aug −12 Jan−13 Jun−13 Nov−13 Apr−14 Sep−14 Feb−15 Jul−15 Dec−15 May−16
There may be significant inflows
those of equities or fixed income. What is more, REITs draw from sources of return of both of these asset classes. Like bonds, they may offer more income certainty due to the longer-term nature of leases typical in most REIT subsectors. On the other hand, the mark-to-market character of leases provides equity-like exposure to the economic cycle.
Yield differential (percentage points)
income taxes but are taxed at the investor level, like income from direct real estate holdings.
Difference
Long-term average
Source: Bloomberg and Merrill Lynch Chief Investment Office. Note: REITs as measured by the FTSE NAREIT All Equity REITS Total Return Index. Data as of May 31, 2016. Past performance is no guarantee of future results.
Portfolio Considerations: REITs’ equity-like upside, attractive yields, diversification properties and the exposure they offer to the Real Estate asset class could make them good additions to strategic portfolio allocations for investors. The nearterm tailwind from the GICS sector breakout may also help. While passive allocations could reap their benefits, active management might better position portfolios as economic and market conditions favor certain REIT sub-sectors and even individual firms.
BofAML Global Research. April 27, 2016. “U.S. REITs: Countdown to the REITs breakout – expanded scenarios around potential inflows.” Cohen & Steers. March 2016. “Real Estate in a Class of Its Own: How the New Real Estate GICS Sector Classification Could Bring a $100 Billion Influx of Demand and Lower Volatility.”
CIO REPORTS • The Weekly Letter
2
Markets in Review Trailing Economic Releases
Equities
Initial
jobless claims in the U.S. edged down to 264,000 for last week, compared to 267,000 the prior week and consensus expectations of 270,000.
The
University of Michigan Consumer Sentiment Index came in at 94.3 for June versus 94.7 in May and consensus expectations of 94.0.
German
CPI stood at 0.3% MoM for May, in line with the consensus. For the prior month it was -0.4%. YoY it came in at 0.1%, in line with expectations and a reversal from the prior month´s -0.1%.
Yield (%)
S&P 500 Sector Total Returns (week-to-date)
-2%
-1%
2.8% 1.4% 1.1% 1.0% 0.8% 0.2%
0%
Total Return in USD (%) WTD MTD YTD 0.4 0.5 3.9 -1.0 -1.1 -1.7 -0.1 0.0 3.6 -0.1 0.5 8.0 0.0 0.8 3.1 -0.8 -0.5 1.3 -1.7 -1.5 -2.6 1.0 2.2 4.5
Fixed Income
S&P 500 Sector Returns (as of last Friday’s market close) Telecom Energy Consumer Staples Utilities Industrials Materials -0.3% Information Technology -0.8% Health Care -0.8% Consumer Discretionary Financials -1.5%
DJIA NASDAQ S&P 500 S&P 400 Mid Cap Russell 2000 MSCI World MSCI EAFE MSCI Emerging Mkts
Level 17,865.3 4,894.5 2,096.1 1,499.1 1,163.9 1,665.2 1,640.9 823.8
ML US Broad Market ML 10-Year US Treasury ML US Muni Master ML US IG Corp Master ML US HY Corp Master
1.96 1.64 1.78 2.98 7.24
Total Return in USD (%) WTD MTD YTD 0.4 1.0 4.6 0.5 1.6 6.1 0.6 0.8 3.6 0.5 1.3 6.6 0.9 0.9 9.1
Commodities & Currencies
1%
2%
3%
Bloomberg Commodity WTI Crude $/Barrel1 Gold Spot $/Ounce1 Level EUR/USD USD/JPY
Level 179.5 49.07 1,273.92 Current 1.13 106.97
Total Return in USD (%) WTD MTD YTD 2.1 4.2 13.4 0.9 -0.1 32.5 2.4 4.8 20.0 Prior Prior 2015 Week End Month End Year End 1.14 1.11 1.09 106.53 110.73 120.22
Source: Bloomberg.1 Spot price returns. All data as of last Friday’s close. Past performance is no guarantee of future results.
Looking Ahead In the U.S., the National Association of Home Builders (NAHB) housing index is expected to slip, and housing starts to decline. Eurozone Consumer Price Inflation (CPI) for May is expected to increase from the prior month. Upcoming Economic Releases On
Thursday in the U.S., the NAHB housing index is expected to slip to 57 for June after holding at 58 for the prior four months.
On
Friday, U.S. housing starts are expected to fall to 1.12 million for May with both single and multi-family building edging lower.
On
Thursday, Eurozone Core CPI YoY for May is expected to come in at 0.8% vs. 0.7% in the prior month.
BofA Merrill Lynch Global Research Key Year-End Forecasts S&P 500 Outlook Target
2016 E 2,000
EPS
$120.00
Real Gross Domestic Product
2016 E
Global
3.1%
U.S.
1.8%
Euro Area
1.5%
Emerging Markets
4.0%
U.S. Interest Rates
2016 E
Fed Funds
0.63%
10-Year T-Note
2.00%
Commodities
2016 E
Gold $/Ounce
$1,234
WTI Crude Oil $/Barrel
$54.00
All data as of last Friday’s close. CIO REPORTS • The Weekly Letter
3
CHIEF INVESTMENT OFFICE Christopher Hyzy
Chief Investment Officer Bank of America Global Wealth and Investment Management
Mary Ann Bartels
Karin Kimbrough
Niladri Mukherjee
Head of Merrill Lynch Wealth Management Portfolio Strategy
Head of Macro and Economic Policy Merrill Lynch Wealth Management
Managing Director Chief Investment Office
Emmanuel D. Hatzakis
Jon Lieberkind
John Veit
Director
Vice President
Vice President
The opinions expressed are those of the Merrill Lynch Chief Investment Office only and are subject to change. While some of the information included draws upon research published by BofA Merrill Lynch Global Research, this information is neither reviewed nor approved by BofA ML Global Research. This information and any discussion should not be construed as a personalized and individual recommendation, which should be based on your investment objectives, risk tolerance, and financial situation and needs. This information and any discussion also is not intended as a specific offer by Merrill Lynch, its affiliates, or any related entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service. Investments and opinions are subject to change due to market conditions and the opinions and guidance may not be profitable or realized. Any information presented in connection with BofA Merrill Lynch Global Research is general in nature and is not intended to provide personal investment advice. The information does not take into account the specific investment objectives, financial situation and particular needs of any specific person who may receive it. Investors should understand that statements regarding future prospects may not be realized. No investment program is risk-free, and a systematic investing plan does not ensure a profit or protect against a loss in declining markets. Any investment plan should be subject to periodic review for changes in your individual circumstances, including changes in market conditions and your financial ability to continue purchases. Asset allocation and diversification do not assure a profit or protect against a loss during declining markets. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates, and risk related to renting properties, such as rental defaults. In addition to the risks associated with direct ownership in real estate, REITs may carry additional risks because they are dependent upon management skills, may not be diversified, are less liquid and are subject to heavy cash flow dependency, defaults by borrowers and self-liquidation. A REIT could also fail to qualify for tax-free pass-through of income under the Internal Revenue Code or fail to maintain its exemption from registration under the Investment Company Act. Neither Merrill Lynch nor any of its affiliates or financial advisors provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions. The investments discussed have varying degrees of risk. Some of the risks involved with equities include the possibility that the value of the stocks may fluctuate in response to events specific to the companies or markets, as well as economic, political or social events in the U.S. or abroad. Bonds are subject to interest rate, inflation and credit risks. Investments in high-yield bonds may be subject to greater market fluctuations and risk of loss of income and principal than securities in higher rated categories. Investments in foreign securities involve special risks, including foreign currency risk and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are magnified for investments made in emerging markets. Investments in a certain industry or sector may pose additional risk due to lack of diversification and sector concentration. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates, and risk related to renting properties, such as rental defaults. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors. Income from investing in municipal bonds is generally exempt from federal and state taxes for residents of the issuing state. While the interest income is tax exempt, any capital gains distributed are taxable to the investor. Income for some investors may be subject to the federal alternative minimum tax (AMT). Past performance is no guarantee of future results. © 2016 Bank of America Corporation
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