To most outside observers, the nosebleed highs of REIT performance is starting to make them queasy. Since 2010, these names have been the top performers for several years. And when the Fed tamped down on its interest rate hawkery this year, the dividend-rich REIT class surged again. 

How rich do you like it? How about year-to-date 50% share price gains for data center REITs like CoreSight and DuPont Fabros Technology by mid-July (followed by 44.5% for Digital Realty)? How about net-lease company Realty Income shares rising 37% for the year? In 2015, self-storage REITs as a group returned 40%. 

With that success comes prices out of whack with consensus analysts’ estimates. Many of these same companies now face double-digit downsides if their consensus prices mean anything.

But REITs aren’t like ordinary small or midcap stocks, say analysts and portfolio managers who’ve been following them a long time. Seeing them as overvalued is a mistake, they insist. 

Why does that matter now? Because REITs are about to get a big spotlight turned on them. On August 31, real estate crawls out from the throng of banks and insurance companies to get its own Global Industry Classification Standard (or GIC standard) in the Dow Jones and S&P indexes. When it does, portfolio managers that overlooked REITs will suddenly find themselves nakedly underweight in the freestanding sector.

The amount of money at stake as they play catchup is big, say analysts at Jefferies. “We estimate that the average manager is 3.3% underweight REITs and each 1% increase in weight represents $46.7 billion in buying pressure,” wrote Jefferies analysts Steven G. DeSanctis and Omotayo Okusanya in a late-April commentary. That pressure is different for different managers (large-cap managers have more ground to make up than small company investors) but the anticipated reallocation among managers, combined with REITs’ continued yield spread above Treasurys, will continue to push the asset class past even its current highs, say fans.

Buildings Already On Bedrock

The specific nature of the housing crisis meant that a lot of the property overbuilding that typically happens during tulip manias (think of the Empire State Building, which was going to serve as a symbol of the Roaring Twenties but instead served as its grave marker) hasn’t happened this time around. Seven years of GDP growth without a lot of new building has led to an undersupply of property at a time of growing demand. That’s the sweet spot for REITs, which like to raise rents organically and pass on that cash to investors (they must pass on 90% of taxable income to investors annually as dividends).

That’s given REITs room to run. J.P. Morgan Asset Management listed REITs as the top returning asset class every year from 2010 to 2014 except 2013. The FTSE NAREIT All Equity REITs Index returned almost 28% in 2010, about 8.25% in 2011, 19.7% in 2012 and 28% in 2014. By May 31 of this year, REITs had still topped most other classes in year-to-date performance with 6.32% (losing only to commodities, which are coming off of basso profondo lows). 

“In U.S. equity REITs, you have a high 3’s dividend yield that’s going to grow by 6% or 7% each year,” says Jason Yablon, senior vice president and portfolio manager at Cohen & Steers in New York City. The healthy fundamentals for cash flow is being driven by demand for real estate “that’s greater than supply in most markets that we are invested in,” he says.

Derek Newcomer, a CFA at Beacon Pointe Financial in Newport Beach, Calif., says even markets like Nashville are seeing historically low levels of vacancy in office space where demand has outstripped supply.

Edward Mui, an analyst at Morningstar, agrees that the sector is fundamentally healthy: “Occupancies are high, rent growth is still pretty strong for many asset classes in many markets, and balance sheet strength leverage is down. People still have liquidity, access to capital, still, especially for the highest quality assets.”

The GIC reclassification is going to bring a lot of generalists into the REIT investing game. Longtime players in this space say these portfolio managers are going to have to really look closely at the asset class and learn how to properly evaluate—not just see overvalued stocks, says Michael Underhill, the CIO at Capital Innovations in Pewaukee, Wis.

“In place of traditional valuation metrics like earnings per share, price to earnings and price-to-book value, REITs utilize factors such as funds from operations (FFO), net asset value (NAV), capitalization rates and internal rates of return (IRR),” Underhill says. “These terms are simply not understood by most generalist investors.” REIT specialists, on the other hand, will better understand industry valuation methods; do on-site property inspections; and go meet with property managers, tenants and leasing agents, he says. 

Over the last 10 years, the dispersion between the best and worst performing REITs is 35%, says Yablon. That creates room for active managers.

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