At the end of August, benchmark providers Standard & Poor's, Dow Jones and MSCI will promote real estate from an industry group within the financial sector to a sector of its own. As such, real estate will become the 11th sector within the Global Industry Classification Standard framework. (The other 10 are: consumer discretionary, consumer staples, energy, financials, health care, industrials, information technology, materials, telecommunication services, and utilities.)

The addition of the real estate sector is the first since the creation of the GICS structure in 1999, and will provide the newest sector with greater visibility within investment indexes. The newly minted sector will include real estate investment trusts, real estate management companies and development companies. Mortgage REITs will stay classified within the financial sector. This move is a validation of liquid real estate securities as a distinct asset class with a place in every diversified investment portfolio.

We expect this sector change will have a material impact on listed real estate securities due to the extent that the investment community follows the GICS framework. As the basis for many indexes and performance attribution systems, GICS provides the structure for the way many investors view this universe. With the status as a sector, it will be more difficult for generalist investors, such as a mid-cap value manager to ignore real estate. Historically, many of these managers would avoid REITs or significantly under-represent this sector by overweighting other securities within the broader financial sector. With real estate as a standalone sector, it will be more obvious when a manager is significantly underweighting it, resulting in some managers increasing their holdings.

Currently, REITs are represented in the major U.S. equity indexes. As an example, 2.7% of the S&P 500, 10.9% of the S&P Mid Cap 400, and 7.8% in the S&P Small Cap 600 are real estate related stocks, according to S%P.

Moreover, using Morningstar's nine domestic equity style boxes, the highest percentage of REITs are in the in the mid-cap value (15%) and small-cap value (15.3%) segments. But the average mutual fund managers in these categories have allocations of about 6% to REITs in both style box regions, according to Morningstar data, which is a substantial underweight.

No Surprises
Historically, real estate was not a common portfolio holding except for institutional and ultrahigh-net-worth individuals. So while the reclassification of real estate to a GICS sector is a newsworthy milestone, here at U.S. Bank Wealth Management, it doesn't change the weighting that real estate holds in our strategic asset allocation. We see real estate as one of four cornerstone asset classes, along with equities, fixed-income and commodities so it’s business as usual for us. Over the past three decades, real estate has been recognized as a meaningful and mainstream asset class that can be a valuable component of an investment portfolio.

With real estate as a standalone sector, it will be more obvious when a manager is significantly underweighting it, resulting in some managers increasing their holdings.

Indeed, as part of our asset allocation guidance, we will recommend investments in real estate through a variety of products. The best way to attain exposure to real estate is on a case-by-case basis. It depends on the client's asset levels, risk tolerance and liquidity needs. We're able to help clients on real estate investments no matter the form: direst investment, private real estate funds, non-traded REITs, and listed real estate securities that include stocks, mutual funds and ETFs.

We help clients manage their direct real estate investments, such as an industrial warehouse, multifamily apartment complex, farmland or timberland. Our asset allocation guidance to clients provides for a combination of ownership structures including direct and listed securities. The differing characteristic of direct investment and REIT mutual funds can be a benefit in a client's portfolio by providing a layer of diversification within the asset class. Real estate investments, no matter the form, can contribute to a diversified portfolio due to return patterns, comparative performance relative to other asset classes, the potential for inflation protection and the cyclical nature of different property types. Direct ownership or some form of indirect ownership in real estate has historically provided diversification benefits in part due to the combination of income and capital appreciation potential.

At U.S. Bank Wealth Management, we believe that the promotion of real estate as a sector will prompt many benchmark-aware managers to move to a more neutral positioning, which will increase their allocation to real estate names. This will likely provide additional price support and liquidity to REITs, especially for index investors. The reclassification of real estate to a GICS sector is an important transition for this asset class and advisers will likely consider the wide range of real estate investments in their investment strategies for clients.