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. 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 interest rates had stagnated at still relatively low levels. However, the recent shift in sector leadership to more defensive groups  that we observed late last year, combined with our belief that the “death of brick-and-mortar retailers” story is overdone, led us to upgrade our rating of the real estate sector to marketperform from underperform. The sector also has benefited from the overall market volatility over the past couple of months. Home affordability is near 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 in our minds fewer than a few months ago. For instance, apartment demand has been strong and rental rates have risen—but as often happens, businesses have seen a need and rushed to fill it, which could result in an eventual oversupply in the apartment area. Retail REITs also face some headwinds, but, as mentioned, this is an area on which we’re becoming more positive. As longtime readers of this publication know, I am not a believer in the “death of brick-and-mortar” story that seems to be told quite often. From media reports you would think online sales have completely overtaken brick and mortar, but e-commerce made up only about 9.8% of total retail sales at the end of Q3, according to the U.S. Census Bureau.

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 rose but have since backed off, with the  10-year Treasury yields moving well below the 3% level. That’s still low by historical levels, but a renewed move higher would cause us more concern.

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.

 

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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