Breaking down the real estate rally
Since mid-May, real estate has been the best-performing sector of the S&P 500, with a total return of 23 per cent. That is 13 points ahead of the market. Can the sector continue to lead?
The main reason real estate has done well over the past three months is that it is rate sensitive. The sector is mostly made up of investment trusts that are owned for their yields; lower rates make those yields more attractive. Relatedly, higher rates bring down the valuations of the assets Reits own, and threaten the most leveraged and lowest quality assets with default. So the sector fell a lot after the Fed started to raise rates in 2022, and has taken a lot of those losses back now that the central bank has signalled its readiness to cut.
The futures market’s best guess is that the Fed’s policy rate will fall from 5.25 per cent now to a bit under 3 per cent two years from now. If that’s about right, and the yield curve regains its normal shape, longer term rates would be in the range of 3.5 per cent to 4 per cent, or 1 to 1.5 percentage points above their level before the inflation shock. That difference is important, because not all of real estate’s rate-driven losses will be regained if rates don’t return to the old lows. Indeed, it is likely that much of the coming decline in rates is priced into real estate stocks already. Barring a further decline in rate expectations, fuel for further sector gains will have to come from elsewhere.
Which segments of the market still have room to recover? Two groups of Reits stand out. Office Reits (Boston Properties, Alexandria, Healthpeak) are still down more than 30 per cent from the peaks and offer dividend yields of 4 per cent to 5 per cent. If you think rates are going to fall fast enough for the office industry to recover before a default wave hits, there is an opportunity there. Apartment Reits (Camden, UDR, Mid-America Apartment, Equity Residential) are still down 10 per cent to 20 per cent and have yields of 3 per cent to 4 per cent. Rent inflation, which spiked wildly in 2021, is now lower than before the pandemic. Might it heat up a bit?
The easy money in the real estate sector has probably been made. Future gains will be earned by investors who know exactly what they are buying.