Generous dividends and relatively secure cash flows have been the hallmarks of real estate investment trusts (REITs) in recent years, but some investors fear that all REITs are too expensive. We think it’s time to take a closer look.

REITs have a new home in equity indices. The S&P Dow Jones and MSCI equity indices recently shifted REITs from the financials sector to the new real estate sector. As a result, real estate stocks’ weight in the indices, and in investor portfolios, has become much more transparent. This new placement also points to REITs’ growth and increasing importance over the past decade—and could help prompt fresh consideration of the asset class.

BREAKING DOWN INVESTOR RELUCTANCE

Still, some investors are hesitant to jump into US REITs. Many investors are understandably wary because of the often indiscriminate hunt for yield in recent years. They worry that REITs have significantly outperformed the overall market, leaving them expensively priced.

In reality, returns for US REITs and the S&P 500 have been fairly similar for the past three-, five- and 10-year periods. For example, the S&P 500 and US REITs delivered total annual returns of 16.4% and 16.2%, respectively, over the five years ended September 30, 2016 (Display).

The sources of these returns have been quite different, though. In the past five years, 61% of the S&P 500’s gains have been a result of an increased price/earnings multiple, versus only 26% for US REITs. In contrast, US REIT returns have been strong primarily because of dividends paid and cash-flow growth, generally considered higher-quality sources of returns.

WHAT’S NEXT FOR REITS?

REIT fundamentals remain healthy, in our view, for most commercial real estate property sectors, including office, retail, residential and industrial. Supply growth has been restrained in the aftermath of the global financial crisis. Although new development has recently begun to increase, it is rising from very low levels. Even a continuation of modest US economic growth should lead to ongoing cash-flow growth, which analysts estimate will rise about 6% from 2016 to 2017.