I won't keep you in suspense. If you had invested $1,000 in the Vanguard Real Estate ETF (VNQ 0.03%) a decade ago, you would have about $1,770 today, assuming you reinvested your dividends along the way.
This isn't a terrible outcome. After all, you wouldn't have lost money. But when you consider that $1,000 invested in an S&P 500 index fund such as the Vanguard S&P 500 ETF (VOO -0.03%) 10 years ago would be worth $3,900, it doesn't exactly look like stellar performance.
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What went wrong?
The short version is that the real estate sector underperformed the S&P 500 because, first, the S&P 500 has been on an incredible bull run. It has produced annualized total returns of about 14.6% over the past decade, making it touch to beat.
In addition, real estate is perhaps the most rate-sensitive sector of the market. Over the past 10 years, we've seen two prolonged periods of Federal Reserve rate increases, with a global pandemic in between. In fact, the benchmark federal funds rate is more than 400 basis points higher than it was a decade ago.
Real estate investment trusts (REITs) have a strong history of outperforming the market in falling rate or zero-rate environments but underperforming when rates are high or rising.
Without turning this into an economics lesson, there are a few reasons REITs are so sensitive to interest rates. One is borrowing costs. REITs tend to rely heavily on borrowed money to grow, similar to how you might rely on a mortgage to buy a home. Rising rates make the economics of borrowing less favorable.
In addition, rising rates put pressure on commercial real estate property values, which tend to have an inverse relationship with risk-free interest rates (those offered by Treasury securities). The properties REITs own can literally be worth less simply because rates went higher.
On the other hand, it's worth noting that these things can also become real estate's biggest catalysts in a falling-rate environment.
