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Real estate sector

Real Estate Sector Rating: Underperform

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 but now appears to be lessening as rates tick higher. 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.

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, apparently enticing investors to do a little “yield chasing.” But chasing interest rates and replacing some fixed income investments with higher-yielding equity securities can be a dangerous game to play and should interest rates again start to rise, which is a very real possibility, the sector would be in danger of some of that flow turning in the opposite direction.

There are other issues for concern as well, although perhaps 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 concerned about occurring in the apartment area. We've also seen some evidence, such as a report from the National Association of Realtors, that Millennials are increasingly moving out of apartments and their parents’ basements and into houses. Retail REITs also face some headwinds, but this is an area where we’re becoming a little less bearish. As long-time readers of this publication know, I am not a believer in the “death to brick-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 online only made up roughly 9.5% of total retail sales according to the U.S. Census Bureau as of the end of Q1. But the trend is still in the online direction and we think that will keep pressure on the mall REITs for the forseeable future.  

The final concern may be becoming our biggest. REITs have been able to borrow money at low rates in order to increase their holdings and potentially their income. But rates have risen and could rise further, increasing their financing costs and decreasing the amount they have available to pay out investors.For now these concerns leave us in the underperform camp, but there are developments that could lead to a change in the not-too-distant future.

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:

  • Continuation 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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