Real Estate Gets Its Own Sector

2/1/2016


Regular readers have probably heard us refer to the 10 market sectors many times. That will change on Aug. 31, when Standard & Poor's plans to pull real estate stocks out of the financial sector to form their own freestanding sector.

We typically rely on S&P's sector classifications, though they've always been somewhat arbitrary. Other index providers and financial-media players use their own groupings, and on occasion so have we.

Real estate behaves differently than most financials, so we can't argue with S&P's move. Yet whenever changes like this occur — more often than most investors realize — they muddy the data used by analysts such as us. S&P doesn't build historical data stores, which means historical comparisons for both the real estate and financial sectors won't be entirely clean. Still, the market will adjust to the change, and so will we. 

At the moment, the real estate group within the financial sector encompasses two industries — real estate investment trusts (REITs) and real estate management & development. You can expect more on the real estate sector later in the year, after S&P provides a complete list of its stocks. But here are a few tidbits you should know now:

• S&P recognizes seven kinds of REITs, and six will join the new sector. Mortgage REITs, which own mostly mortgage loans, will remain part of the financial sector. The move befits their focus on investing, rather than real estate ownership and management.

• Most of the companies in real estate management & development will probably move to the new sector, but we can't be sure. Nor can we rule out the possibility that stocks from other groups might migrate to the new real estate sector.

• The S&P 1500 Index contains 95 real estate stocks, of which 91 (96%) are REITs. REITs also make up 98% of the group's market value. Even after losing mortgage REITs, we expect REITs to dominate the new sector.

• Once S&P releases the makeup of the new sector, we'll create 12-Factor Sector and Reranked Overall scores for it, just as we have for the 10 current sectors. We'll also update the other sector-specific scores, as we do every few years. For more on our sector-specific scores, visit www.DowTheory.com/Go/Sectors. The 12-Factor score considers a dozen individual statistics the work well in a sector, while Reranked Overall reweights the same six categories used for the traditional Overall score.

• At the moment, we recommend just two real estate stocks, CBRE Group ($28; CBG) and Jones Lang LaSalle ($137; JLL). We address the outlook for both stocks below.

CBRE and Jones Lang LaSalle share several characteristics. Both:

• Generate the bulk of their revenue from real estate management & development, but also operate investment businesses.

• Earn Overall Quadrix scores of 96, tied for tops among S&P 1500 real estate stocks.

• Have delivered impressive growth in recent years yet trade at a modest valuation.

• Have been aggressive acquirers in recent months.

• Are components of our Focus List.

• Have fallen at least 9% so far this year, hurt in part by concerns about the strong U.S. dollar, higher interest rates, and slowing growth in China and other emerging markets.

• Plan to release December-quarter earnings Feb. 3.

CBRE manages about 5 billion square feet of real estate, with 2.3 billion in the Americas and the rest roughly split between the Asia-Pacific region and Europe/Africa. However, size has not hindered growth.

Sales rose 17% in the 12 months ended September and 16% annually over the last three years. CBRE delivered double-digit growth in each of the last 11 quarters, and an acquisition last year should keep that trend going at least for the next year. The consensus projects profit growth of 15% in the December quarter and 14% for 2016.   

Jones Lang's per-share profits rose 16% in the 12 months ended September and 26% annualized over the past three years. While the strong dollar cut revenue growth nearly in half during the first nine months of 2015, both the real estate and investment units managed at least 18% growth in local currencies; more than 60% of revenue came from overseas. 

Investors need not pay up for the growth, given the company's trailing price/earnings ratio of 14 — 21% below its five-year average and cheapest among real estate managers & developers.The industry average is 20.

THE ANATOMY OF TWO SECTORS
While we can't yet be sure which stocks will end up in Standard & Poor's new real estate sector, analysis of real estate stocks relative to the rest of the sector suggests the financial sector's average yield will decline with the loss of the real estate investment trusts (REITs), and its average valuation ratio will decline with the loss of pricier real estate stocks as a whole. In addition, REITs will dominate the new sector to the point that we might as call it the REIT sector rather than real estate.
Current
Financial
Sector
New Real
Estate
Sector
REITs
(Excluding
Mortgage
REITs)
Managers &
Developers
Rest Of New
Financial
Sector
Number of companies
302
95
91
4
208
Total market value ($ bil.)
3,309
713
696
17
2,596
% of financial sector
100
22
21
1
78
Avg. dividend yield (%)
3.2
4.7
4.9
0.3
2.5
Average valuation ratios
Price/earnings ratio
20
37
37
20
14
Versus 5-year average
0.89
0.91
0.92
0.74
0.89
Price/book ratio
1.7
2.6
2.6
2
1.3
Versus 5-year average
0.96
1.00
1.01
0.78
0.95
Average total return
3 months (%)
(10)
(4)
(3)
(20)
(13)
12 months (%)
(7)
(10)
(10)
(21)
(6)
3 years, annualized (%)
9
7
7
1
9
Average Quadrix scores
Momentum
56
57
58
55
56
Value
56
31
30
54
67
Quality
62
59
59
71
63
Financial Strength
68
54
54
40
75
Earnings Estimates
50
59
59
62
47
Performance
55
64
65
33
52
Overall
62
47
46
59
69
Note: Quadrix scores are percentile ranks, with 100 the best.

REITs have role, but not on Buy List

A lot of people like to own real estate. The asset class has value as an inflation hedge and a diversification tool. However, few people have the resources to purchase a diversified portfolio of real property — not to mention the time and expertise to manage it.

For most of us, real estate investment trusts (REITs) represent the best way to gain diversified exposure to real estate. Most REITs own and manage such property as office buildings, warehouses, shopping centers, and apartment complexes.

REITs can diversify a portfolio containing common stocks and bonds, albeit not as well as would the returns of real property. While REITs are trust units rather than common stocks, they trade on exchanges and in most other ways behave like stocks. For more on how REITs work, visit www.DowTheory.com/Go/REITs.

Historically, REITs have delivered solid returns, with the MSCI U.S. REIT Index returning 655% (10.6% annualized) since the end of 1995, well above the S&P 500 Index's 348% return (7.4%). But there's a reason we don't have any REITs on our buy lists. Actually, there are at least three:

1) Quadrix scores: REITs in the S&P 1500 Index average Quadrix Overall scores of 46, below the average of 62 for the financial sector. Only 3% of REITs earn Overall scores of at least 80, our typical cut-off for new buys. In contrast, 26% of financial stocks earn Overall scores of at least 80.

2) Pricey valuations: As a group, REITs look expensive, averaging Quadrix Value scores of 30. REITs average price/earnings ratios of 37 and price/book ratios of 2.6, at least 50% above the average for the broad financial sector (as currently constituted).

3) Complex income taxes: REITs can avoid corporate taxation if they return at least 90% of net income to unit holders — which explains how they can afford such fat dividends. However, some REIT payouts are not qualified, which means investors must pay taxes at ordinary-income rates, rather than the lower rate for most dividends. Further complicating matters, REITs may also return some capital to investors, which can lower the shares' cost basis.

While we don't recommend any REITs, many investors wish to own them for their yields, or for diversification purposes. With that in mind, we created the Alternative Income Watch List (www.DowTheory.com/Go/Alt), which rates 50 REITs A (above average), B (average), or C (below average). We also developed special 12-Factor and Reranked Overall scores designed to rank REITs relative to other REITs — kind of like our sector-specific scores (www.DowTheory.com/Go/Sectors).

Our best REIT picks

Of the 50 real estate investment trusts (REITs) on our Alternative Income Watch List, only the 11 below earn ratings of A (above average) relative to other REITs. None of the REITs listed below would warrant an A rating on our Monitored List.
Total Return
-------------- Quadrix Scores --------------
Company (Price; Ticker)
Div.
($)
Yield
(%)
3
Mos.
(%)
12
Mos.
(%)
Value
Overall
12-
Factor
Sector
Reranked
Overall
Avalonbay ($176; AVB)
5.00
2.8
(1)
0
16
49
79
52
Boston Properties
($119; BXP)
3.85
3.2
(1)
(15)
30
54
49
48
Camden Property Trust
($74; CPT)
2.80
3.8
(4)
(5)
33
64
55
49
Hospitality Properties
($23; HPT)
2.00
8.8
(11)
(26)
75
77
72
92
Kimco Realty ($26; KIM)
1.02
3.9
(1)
(3)
23
40
86
41
Lamar Advertising
($55; LAMR)
2.76
5.0
(1)
2
42
91
100
96
LaSalle Hotel Pptys.
($22; LHO)
1.80
8.3
(24)
(47)
77
45
47
3
Mid-America Apart.
($92; MAA)
3.28
3.6
8
16
38
88
98
100
Public Storage ($248; PSA)
6.80
2.7
7
25
9
72
99
93
Simon Property
($186; SPG)
6.40
3.4
(9)
(6)
22
67
96
82
UDR ($36; UDR)
1.11
3.1
1
8
8
48
97
86
Notes: Quadrix scores are percentile ranks, with 100 the best. The 12-Factor and Reranked Overall scores are special rankings we designed to compare REITs solely to other REITs.

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