The real estate sector has been one of the worst-performing parts of the stock market recently. Although the S&P 500 is up by 50% since the start of 2023, rebounding nicely from the 2022 bear market lows, the real estate sector, as indicated by the Vanguard Real Estate ETF (VNQ +1.36%), is up by just 6% in the same period. Even including dividends, real estate has underperformed the S&P 500 by 37 percentage points over the past year and a half.
While this has certainly not been a fun time to be a real estate investment trust (REIT) investor, there's good reason to believe that things are about to turn around. With that in mind, here's why real estate has performed so poorly as a sector, why things might be about to get better for REITs, and why now could be a great time to get some exposure.
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Key Data Points
Why has the real estate sector performed so poorly?
The biggest reason real estate has underperformed is the rising-rate environment of the past couple years.
Without getting too deep into an economics lesson, the key point to know is that when risk-free interest rates rise (Treasury securities, for example), it tends to put pressure on income-oriented investments like REITs. Think of it this way: When instruments like Treasuries pay more, the yields investors expect from "riskier" investments tend to rise as well. Since yield and price have an inverse relationship, rising yields put downward pressure on REIT prices, even when the underlying business is doing well.
Not only do rising rates generally put pressure on income-focused investments, but they also make it more expensive to borrow money. While this can affect businesses in all sectors, REITs tend to be more reliant than most on debt to grow their business, similar to how most homeowners use a mortgage when buying a home.
It also hasn't helped that the surge in AI investment has caused investor sentiment to shift in favor of massive tech stocks like Nvidia (NVDA +0.87%) and Microsoft (MSFT +1.01%). We've already started to see some money rotate out of the high-flying AI winners and into income-based stocks like REITs just based on recent inflation data, and this could accelerate once the Federal Reserve actually starts to cut rates.
Last but certainly not least, we've seen some headwinds specific to certain property types. One big example is the communications REITs: American Tower (AMT +1.60%) and Crown Castle (CCI +4.89%). Both are experiencing a challenging growth environment, and since they're both among the largest REITs, they have a disproportionate drag on the index. Plus, some sectors have dealt with oversupply headwinds, such as office and self-storage real estate.
Could a major turnaround be right around the corner?
The Federal Reserve hasn't raised interest rates in 2024, but investor expectations have certainly changed. At the beginning of the year, the median expectation was for a total of six rate cuts in 2024, but the inflation data and Fed officials quickly told a different story. And that's the biggest reason why real estate has underperformed so far this year.
However, the latest inflation data indicates that it might actually be time for the Fed to start seriously considering rate cuts. According to CME's FedWatch tool, the first rate cut is clearly expected in September, a total of three are expected by the end of the year, and the median expectation is now for six total cuts by July 2025. In other words, the falling-rate cycle is set to begin -- just a little later than originally anticipated.
As rates fall, investor money could start to flow out of risk-free instruments like Treasuries, money market funds, and savings accounts, and into high-yielding stocks like REITs. And if the recent market activity is any indicator, we could also see a bit of a rotation out of the high-flying megacap tech stocks that have largely led the market's performance.
There's no guarantee, but...
To be perfectly clear, there's no way to know for sure how REITs will perform for the rest of 2024 and beyond, or if the Fed will actually start cutting interest rates. If inflation data for the next few months doesn't look great, it's entirely possible rates could stay higher for longer than expected.
Having said that, investing in REITs when the real estate sector is down by 25% from its all-time high, as it is now, has historically been a very strong entry point for long-term investors. There are some excellent values in individual REITs right now, but if you'd rather get broad exposure to the sector to hold for the long run, an ETF like the Vanguard Real Estate ETF could be a fantastic addition to your long-term portfolio right now.
