US Markets

Real estate sector to be added to S&P 500

Real estate realities: Sam Zell

A change is coming for the that likely will see billions pumped into real estate-related investments.

The popular stock market index will add a sector to the 10 broadest categories into which it is divided. That 11th sector will be real estate, an industry currently stuffed inside the financials group but set to break out on its own when the change takes place Aug. 31.

While the move on its face seems cosmetic, the actual ramifications could be substantial.

Most Wall Street experts foresee a substantial inflow to the new sector, with particular focus on real estate investment trusts. On the high end, JPMorgan Chase reportedly estimates that as much as $100 billion could come in. Others are bit more cautious, with Goldman Sachs putting the number close to $19 billion and Bank of America Merrill Lynch expecting considerably less, with $8 billion on the top end.

Investors looking to capitalize on the expected flows will have a number of considerations to weigh, Nick Colas, chief market strategist at Convergex, said in a recent note on the topic. Colas recommends watching not individual REITs and related stocks, but rather exchange-traded funds that track the sector.

Top real estate ETFs by assets

"We think that real estate ETFs will be an important 'tell' about the size of the shift. They are already seeing anomalously strong flows, and we are still months away from the Aug. 31 change," Colas wrote. "Many active managers may choose to use these products to achieve their equal-weight position, rather than dedicate analytical resources to the group."

The reason for the expected money flow into real estate is twofold: First, professional portfolio managers who practice diversification now will have another sector to which to allocate. Real estate is likely to take up about 3 percent of the $17.8 trillion S&P 500 market cap, or about the same as the utilities and materials sectors.

Second, most portfolio managers are underweight financials and real estate already, increasing the probability of some shift particularly if the change gives the sector a boost.

Financials as a whole are off narrowly year to date though real estate was up about 2.2 percent as of Wednesday trading. The S&P 500 as a whole has gained 2.4 percent in price.

Goldman does not believe allocation to the new sector will be as pronounced as some others on the Street expect.

"Active managers are underweight real estate stocks across mutual fund types (core, growth and value)," David Kostin, Goldman's chief U.S. equity strategist, said in a note this week. "However, while we expect funds with no REIT exposure will drive demand for stocks in the newly independent real estate sector, funds underweight real estate positions will likely keep their sector allocations unchanged."

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Funds collectively are underweight, or holding less than the index balance, by 1.17 percentage points, which is the most of any sector, Kostin said. Real estate alone is underweight by 1.36 percentage points. But there's no guarantee those positions suddenly will shift because real estate is getting its own sector.

"Diversified fund managers who are currently underweight REITs are unlikely to suddenly move to a market weight position in real estate just because the industry group is reclassified as a sector," Kostin said.

Indeed, Convergex's Colas said the REIT trade is no "layup."

One of the big considerations: the Federal Reserve. The U.S. central bank is expected to hike rates at least once in 2016. Dividend-payers like REITs could be adversely impacted should the Fed get more aggressive about tightening monetary policy. He thinks, though, that real estate deserves a careful examination as the market prepares for the new-look S&P 500.

"Still, the marriage of a low-yield investment environment and a low-growth but stable domestic economic environment seems tailor-made for real estate," Colas wrote. "This may not be layup, but it's not a three-point shot at the buzzer either."