Real Estate Sector Rating: Marketperform

Real estate sector overview

Low interest rates can make dividend-paying equity real estate investment trusts (REITs) more attractive, a factor that has supported them in recent years. Apartment and office markets have been generally strong, supporting rents; however, supply is rising, which could pressure profitability. Also, an ongoing shift away from brick-and-mortar retailers could pressure mall REITs, but that story seems well known and we recently upgraded the sector to marketperform.

Market outlook for the real estate sector

The real estate sector has outperformed at times in the recent past as longer-term rates have stagnated at still relatively low rates, and with the recent shift of sector leadership to more defensive group that we’ve observed, combined with the our thought that the story of the death of brick-and-mortar retailers is overdone at this point lead us to upgrade our rating of the real estate sector to marketperform from underperform. Home affordability is also at a 10-year low, according to the National Association of Homebuilders, which could lend support to the apartment area of the market.

There are still areas for concern, but it our minds less so than a few months ago. For instance, apartment demand has been strong and rental rates have risen, the laws of supply and demand remain in force. But as often happens, businesses see a need and rush to fill it, resulting in an eventual oversupply, something we’re still concerned about occurring in the apartment area.. Retail REITs also face some headwinds, but, as mentioned, this is an area where we’re becoming more positive on. As long-time readers of this publication know, I am not a believer in the “death to brick-and-mortar story” that seems to be told quite often. And we’ve seen some evidence of that as results from retailers such as Macy’s come in better than expected. And from media reports you would think that online has completely taken over brick and mortar—but e-commerce only made up roughly 9.6% of total retail sales according to the U.S. Census Bureau as of the end of Q2.

One last major concern has been reduced. REITs have been able to borrow money at low rates in order to increase their holdings and potentially their income. Rates have risen modestly, but the 10-year Treasury has seemed have trouble getting above the 3.0% market, easing our concerns about a rapid increase in financing costs for the group, and warranting in our minds a marketperform rating.

Factors that may affect the real estate sector

Positive factors for the real estate sector include:

  • Low interest rates: Low rates have enabled real estate investors to buy property with relatively "cheap" money, which provides the potential for greater income.
  • Expanding economy: An expanding U.S. economy typically helps the real estate area, as rental rates increase for apartments, retail and office buildings.
  • Apartment trends: Due to the financial crisis and housing crash, as well as demographic factors, demand for apartments has been strong, supporting rental rates and benefiting those companies that have a stake in that arena.
  • The change in the tax code could help make REITs more attractive in taxable accounts due to a change in the taxation of passive income.

Negative factors for the real estate sector include:

  • Resumption of rising interest rates: Higher rates would likely raise the cost of financing, and could make the yield provided by the group less attractive.
  • Apartment trends—part 2: This has been a positive factor but we may be at an inflection point, where supply starts to exceed demand and Millennials start to be more attracted to houses.
  • Changing consumer: There has been a move toward online shopping, away from brick-and-mortar stores, which could hurt certain mall-related investments as department stores pare back the number of locations.

 

Clients can see our top-rated stocks in the real estate sector.

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