Over the past two months, real estate investment trusts (REITs), whose performance closely aligns with the direction of long-term yields, have been on fire. I’ve talked about REITs in the past as potentially being winners now that we are in an interest-rate regime shift, but I also recognize that the broader macroeconomic backdrop remains uncertain and challenging.
Real estate has historically been sensitive to interest rate movements. Lower borrowing costs also incentivize businesses to expand operations and invest in commercial properties. Conversely, rising interest rates can dampen demand for real estate, making it less attractive for investors and homebuyers.
REITs, as investment vehicles that own and operate income-generating real estate, tend to be influenced by long-term interest rates. When interest rates fall, the cost of capital decreases for REITs, allowing them to refinance debt at lower rates and potentially improve their profitability. Consequently, investors tend to gravitate toward REITs during periods of declining interest rates, seeking stable income streams and potential capital appreciation.
Real Estate and Interest Rates
Several factors contribute to the potential continuation of real estate’s outperformance amid declining interest rates:
- Lower borrowing costs: Lower interest rates enable real estate developers and investors to access cheaper capital, increasing their capacity for expansion and acquisition activities. This can lead to improved profitability and asset appreciation. The re-evaluation of higher-for-longer rates directly explains REIT outperformance.
- Income-generation: REITs, known for their stable income generation, offer investors an attractive alternative to lower-yielding fixed-income investments. As long as interest rates remain on a downward trajectory, REITs are likely to continue attracting investors searching for reliable cash flows.
- Inflation hedge: Real estate has historically acted as a hedge against inflation. As inflation rises, property values and rental income tend to increase, protecting investors from the eroding effects of inflation. This characteristic makes real estate an appealing investment option, especially in times of economic uncertainty.
Macroeconomic Challenges
While the outperformance of real estate and REITs seems encouraging, it is crucial to recognize the broader macroeconomic challenges that persist:
- Economic uncertainty: The global economy continues to grapple with the fallout of a lagged Federal Reserve. If the Fed overtightened as I’ve long held they already have, it could have knock-on effects when it comes to the broader economy that are very negative.
- Regulatory changes: Alterations to tax laws, zoning regulations or lending practices can create headwinds or tailwinds for real estate investments.
- Market volatility: Despite the current positive trend, financial markets are inherently volatile. Economic shocks, geopolitical tensions or unexpected events can quickly disrupt the stability of real estate markets. Investors should remain cautious and diversify their portfolios to mitigate potential risks.
The Bottom Line on REITs
The outperformance of real estate, particularly REITs, amid declining interest rates, could be a big story next year. The correlation between long-term yields and REIT performance suggests that this trend may continue into 2024.
However, it is essential to consider the macroeconomic backdrop, which remains uncertain and potentially challenging. Housing will likely be challenged on a weaker consumer and supply glut, but other real estate and REITs broadly have the potential to really surprise.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
