OCEAN CITY — Last week, we shopped for yield and growth in the U.S. Consumer Staples sector. This week, we look at Real Estate Investment Trusts (REITs), another U.S. sector we think may provide yield starved investors with both appealing dividend yields and capital appreciation potential. REITs are required by law to maintain dividend payout ratios of at least 90%, making them attractive in a yield-scarce world. Furthermore, we believe they are poised to benefit this year from the growth in technology, the changing U.S. housing landscape, and the secular shift in self storage. REITs, now part of the Financials sector within the Global Industry Classification Standard (GICS) system, will soon break out on their own. REITs becoming a distinct GICS sector represents their entry into adolescence and, therefore, we would expect increasing sector awareness, recognition and inflows. REITs to become their own sector

On Aug. 31, REITs will be removed from the Financials sector within the GICS system and obtain their very own GICS sector. This move will be followed by the sector’s implementation within the S&P 500 Index on Sept. 16.

More inflows and less volatility As a result of REITs being buried inside the Financials GICS sector, U.S. equity funds have been significantly underweight real estate and would need to buy more than $100 billion in REITs to achieve a market-neutral position in the new REIT sector, according to Cohen & Steers. REITs’ volatility may also decline due to increased liquidity and the separation of Real Estate from Financials, historically among the most volatile sectors in the S&P 500. Furthermore, the recently passed Foreign Investment in Real Property Tax Act (FIRPTA) allows overseas investors to own up to 10% of a publicly traded U.S. REIT (up from 5%), and foreign pension funds are allowed to own U.S. real property interests without triggering FIRPTA withholding tax. These changes could bring billions of dollars of foreign investment into the U.S. commercial real estate market. Potential for attractive dividends REITs are required by law to maintain dividend payout ratios of at least 90%, making them attractive in a yield-scarce world. As of the end of March, U.S. REITs offered a dividend yield of 4.2%, versus 2.2% for the S&P 500. The yield differential between REITs and 10-year U.S. Treasuries has been trending upward since 2011 and, as of the end of March, stood at 2.0%, underscoring the relative attractiveness of REITs as a source of income. Additionally, U.S. REITs enjoy attractive dividend growth potential due to their ability to grow distribution both through internal sources, such as healthy fundamentals and redevelopments, and external sources, including acquisitions and developments. Attractivuations REITs outperformed the U.S. stock market year-to-date (through March 31), with a total return of 5.8%, versus 1.4% for the S&P 500. In addition, REIT prices have bounced 18.6% since their February 11 low, in part supported by subdued interest rates. However, despite the recent rally in REITs, the sector is still trading below its five-year price-to-cash flow average of 19.7. Furthermore, BofAML Global Research finds that REITs are trading at 99% of net asset value, versus their long-term average of 101%.

We have argued that REITs can be an attractive source of income due to their generous dividend payouts and one therefore could reasonably infer that REITs behave as bond proxies. In case interest rates accelerate, not our base case, one may thus be concerned about bond sell-offs bleeding into REITs. However, according to BofAML Global Research, the impact of rising rates on REITs should be modest, and evidence is inconclusive on relative performance during previous Federal Reserve tightening cycles. In the last three tightening cycles, REITs underperformed in two and outperformed in one. Thus, history does not offer clear-cut guidance as to how REITs behave in rising interest rate environments.

(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)