Real Estate Sector: 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 group is dominated by equity REITs, entities that invest in physical property and typically receive rental income from their investments. One unique fact about REITs is they are required to pay out to shareholders at least 90% of their taxable income. This can make them an attractive investment in a low-interest-rate environment, as investors look for income. But with our belief that interest rates will continue to rise over the coming year, those investors could start to migrate back to fixed income investments. As a result of this and other factors, we continue to rate the sector at underperform.
There are other issues that concern us, as well. For instance, although apartment demand has been strong and rental rates have risen, the laws of supply and demand remain in force. We've seen the number of apartments being built rise over the past couple of years, leading to increased supply, which could start to moderate rental income gains. We've also seen some evidence, such as a survey from Realtors.org, that Millennials may be starting to move out of apartments and into houses. Finally, retail REITs could face a headwind in coming years, as department store sales have come under pressure and some major retailers have announced they are paring back the number of locations they operate. In fact, recently the Census Bureau reported that department store sales rise a very modest 1.0% over the year-ago period, while non-store retailers (online) rose a robust 13.2%.
For sure, the apartment and office markets have been generally strong, as rents in both areas have gone up over the past several years in much of the country. This is one of the most important things to consider when looking at individual REITs—whether they can maintain or extend their cash flow in order to sustain or increase their payouts. This area has also benefited from low interest rates in another way: cheap financing. REITs have been able to borrow money at low rates in order to increase their holdings and potentially their income. This is another concern for us, that their financing costs could increase in the near future as rates rise.
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.
- Improving economy: An improving 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 recent 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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