Twenty-five years ago, REITs broke through a major barrier to claim a place in S&P indexes—a move that would significantly alter perception of the industry and accelerate its growth in the years to come.
Standard & Poor’s had excluded REITs from its indexes, including the S&P 500, the S&P MidCap 400, and the S&P SmallCap 600, prior to the landmark policy change in October 2001. Reaction was swift, with Sam Zell’s Equity Office Properties Trust becoming the first REIT to join the S&P 500 that same month, followed by Equity Residential in December 2001.
Inclusion in the S&P 500 was a pivotal moment for the REIT industry. It planted the sector more firmly on the map for investors, and it helped to drive significant capital flows to publicly traded real estate companies. Over the past 25 years, REITs have grown from a niche investment opportunity to a major force in the economy. Market cap has surged 10-fold from $147 billion at the end of 2000 to $1.4 trillion today, with 28 public REITs now listed on the S&P 500.
“It was very transformative for the industry,” says Steven Buller, a portfolio manager at Fidelity Investments. Buller has managed Fidelity’s flagship real estate fund, the Fidelity Real Estate Investment Portfolio, since 1998 and closely followed the industry’s advocacy for inclusion in the S&P Indexes.
Broadening the Investor Base
Notably, inclusion in the S&P 500 gave equity REITs access to passive investment capital flowing into the sector through mutual funds and ETFs. Of note, equity REITs joined the S&P 500 on the heels of the launch of the first ETFs in 2000, a market that has since surged to $24 trillion in assets under management.
Participants in the industry that don’t have the tenure back to the 2000s take it as a given that it has always been like this, and it hasn’t, Buller notes. “There were many people behind the scenes that really did a forward push for this inclusion,” he says.
The acceptance of equity REITs into the S&P 500 was another sign of the REIT industry’s growing momentum, adds Mike Grupe, former executive vice president of research & investor outreach at Nareit, now retired. During the 1990s, REITs entered a new era of growth, acquiring more assets and establishing a larger footprint in capital markets. Yet within the broader investment market, real estate remained a relatively small subset of the financials sector rather than a stand-alone category.
REIT industry participants weren’t only pushing for inclusion in the S&P 500; there was a broader movement seeking recognition of real estate as a distinct asset class across other equity benchmarks, including the Russell 2000 and Wilshire 5000. “We developed the data, the analytics, and the arguments, and then we would meet with the various sponsors and organizations of these broad investment benchmarks and make the case for real estate,” Grupe says.
On the Outside Looking In
The S&P Index Committee, which oversaw the selection of stocks into the index, viewed REITs as passive, closed-end investment vehicles or funds rather than traditional operating companies.
“One of the things that struck me as an analyst was that REITs were really pigeonholed,” says Lee Schalop, a former REIT analyst at Bank of America Securities and founder of LSWorks, a firm that provides entrepreneurial support to companies in the life science sector. “REITs were publicly traded, and people invested in them, but it was a very tiny subset of the investment world,” he adds.
As an example, Fidelity had dozens of funds that invested in stocks across different strategies, such as large cap, small cap, value, growth, and income. At the time, Fidelity had one REIT fund. “If a fellow analyst went to Boston to meet with Fidelity portfolio managers, it might mean 30 different meetings because retail was included across different funds. But for REIT analysts, there was one portfolio manager and one meeting,” Schalop says.
Most investors are charged with beating a benchmark, so the manager of a fund tracking the S&P 500 selects stocks from those 500 companies that they believe will outperform the others. If REITs weren’t in any indexes, they weren’t in the pool of stocks those managers considered for their portfolio. As a result, these portfolio managers didn’t want to hear about REITs because they were not included in the indexes against which they were measured, Schalop explains.
“I knew that REITs could never be an important investment as long as they weren't included in the indexes,” he adds. “So, it became a personal goal of mine to change that.”
Schalop started out writing letters to the then chair of the Index Committee at the S&P Dow Jones Indices, David Blitzer, questioning the rationale behind the exclusion. Those letters turned into correspondence over time. Schalop became a key voice in the industry leaders lobbying for REIT inclusion in the S&P 500, which included leading analysts, investors, and REIT executives, such as Zell, David Simon, and Hamid Moghadam, as well as Nareit CEO Steve Wechsler.
Lobbying for Change
Exclusion from the S&P 500 stemmed partly from misconceptions about equity REITs as passive vehicles as opposed to operating companies.
One of the key Nareit arguments at the time was that equity REITs shouldn’t be excluded owing solely to the tax code’s income and dividend distribution requirements because equity REITs were genuine operating companies. “These are companies and corporations that trade every day on stock exchanges. So, they shouldn’t have been treated differently,” Buller says.
REIT operating models were also evolving. Early equity REITs typically bought a building, collected rent, paid expenses, and distributed most of the remaining income to shareholders. That model began changing in the 1990s as REITs became more sophisticated and innovative, finding new ways to develop and modernize their property portfolios, and increase and diversify revenue streams.
“I think the industry had matured sufficiently to the point where most people—analysts, investors, market technicians, and so on—could understand that the equity REIT industry had been developing and maturing for some time,” Grupe says. “It was time to acknowledge that development and maturation and update the investment classification and inclusion rules, and so they did. It was the responsible thing to do.”
A Successful Pitch
A hallmark of the S&P 500 is its representation of the broad U.S. economy. The REIT industry’s advocacy group argued that the most prominent equity benchmark was missing a major part of that economy—real estate. “We told them: ‘Your goal is to have your index represent the U.S. economy, and it doesn’t,’” Schalop says. “That was the hook.”
Nareit worked with other industry participants to assemble relevant data and industry research to present to the S&P 500 Index Committee. According to Grupe, a key ingredient embedded in the presentation focused on the importance of investment diversification across different asset classes in which real estate is a distinct asset class.
For many years, academic research had established the case that investing in an efficient portfolio designed to deliver the maximum return for the minimum amount of risk requires a diversified portfolio. The investment thesis is that, over most investment horizons, not all equity and bond investments perform equally well, with some asset classes outperforming and others underperforming. As such, the optimal portfolio strategy is to build a diversified portfolio that includes some exposure to a diversified mix of asset classes.
Part of the presentation to the S&P 500 Index Committee included analysis that demonstrated that equity REITs performed differently over time than other sectors of the equities market, such as oil and gas, information technology, or commercial banks. “So, if you were going to maintain a broad-based, diversified equity benchmark like the S&P 500 to represent equity investment across the U.S. economy, you had an important sector— real estate—that was not represented,” Grupe notes. Adding equity REITs would bring a new source of diversification into the benchmark, and therefore there was an investment case for doing so, he adds.
Expanding Capital Flows
In addition to meeting key size and liquidity tests, it was important to have someone like real estate legend Zell talk about how REITs had modernized and transformed into operating businesses. But, in Schalop’s view, including investors from outside of the REIT world was key to getting the Index Committee to change its policy.
The industry group that attended the big meeting with the Index Committee in April 2001 included two portfolio managers who managed large funds. Those investment managers candidly said they would never own any real estate stocks until they were in the index because buying something out of the benchmark was taking on a huge risk, Schalop recalls.
“We used the generalist investor base to argue that public real estate companies were an important part of the economy, and yet generalist investors were choosing not to invest in (REITs) because they were not included in the indices that made up their benchmark,” Schalop says. Ultimately, all of those arguments influenced the Index Committee’s decision to change its policy and open its indexes to REITs.
The S&P 500 Index Committee decision, together with other key decisions over the past 40 years, was one piece in a larger puzzle. Importantly, capital markets recognized fundamental changes in how public companies were owning, operating, and investing in real estate, which also changed the flow of investment capital into commercial real estate through equity REITs, Grupe adds.
“The S&P inclusion was a point in time on a journey to promote the REIT industry into a publicly recognized position where it belongs,” he says. “And that, to me, is the broader story.”