The real estate sector has underperformed the S&P 500 (^GSPC 1.52%) significantly over the past decade. The Vanguard Real Estate ETF (VNQ 1.93%) delivered a 77% total return for investors over the past decade, compared with a stellar 290% return from the Vanguard S&P 500 ETF (VOO 1.46%).
It isn't necessarily that real estate investment trusts, or REITs, are doing poorly as businesses. They aren't. Rather, the underperformance can be blamed on two factors.
First is that fact that the S&P 500 -- and especially the megacap technology stocks -- has done incredibly well. And the second reason is interest rates.
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Why interest rates can hurt REIT stock performance
REITs are some of the most rate-sensitive stocks in the entire market, and for a few reasons:
- REITs depend on borrowed money for growth, and higher rates makes borrowing less attractive.
- Commercial real estate values are based on expected rental income potential, adjusted for risk-free rates. In other words, rising rates can push commercial property values lower.
- Higher interest rates can cause an investor rotation out of riskier investments like REITs and into CDs, Treasury securities, and others.
The biggest reason to buy now?
The Federal Reserve is widely expected to gradually lower rates, and chairman Jerome Powell's recent Jackson Hole speech cleared the way for this to start in September.
In the previous section, I mentioned three reasons why rising rates are bad for REITs. Well, they all work the other way too. If rates start to fall, it could create a better growth environment for REITs, cause investors to rotate money into the sector, and generally be an upward catalyst.
