Additional content was provided by Research Analyst Kent Cullinane.
In today's blog, we will be looking at the real estate sector, specifically commercial real estate, analysing the performance and valuation of various industries within the sector and assessing their prospects.
What is Commercial Real Estate?
Real estate is divided into two segments: residential and commercial. Residential real estate consists primarily of single-family homes and apartments, while commercial real estate consists of properties purchased for business use, such as office, retail, industrial, and apartment complexes.
Current state of the commercial real estate sector
Commercial real estate (CRE) has been under immense pressure since the outbreak of COVID-19. Lockdown restrictions have forced employees to work from home and consumers to shop online, resulting in significant vacancies across office and retail properties. Additionally, monetary policy restrictions and rising inflation have significantly increased mortgage payments, driving interest rates as a percentage of loan balances significantly higher and causing some tenants to default on payments. However, the same headwinds that office and retail real estate faced – the shift to remote work and digital shopping – have been tailwinds for industrial and data center real estate.
Regional banks continue to be under close scrutiny due to their relatively large exposure to CRE loans, after suffering large losses in early 2023 due to unrealized losses on their securities and loan portfolios as interest rates rose. Delinquencies are expected to continue as interest rates are expected to remain elevated for an extended period of time and employers move to more flexible work-from-home policies and e-commerce activity increases.
Performance and Evaluation
Given the headwinds facing the real estate industry, it is not surprising that the real estate sector is the worst performing sector year to date and the only one in negative territory. This weak performance has made the real estate sector the smallest sector composition in the S&P 500. Looking at the sub-sectors within real estate, we notice that performance (y-axis) has fluctuated significantly year to date.
Office REITs continue to lag behind their peers
Real Estate Sector Year-to-Date (YTD) Performance and Price-to-Fee (PFFO) Ratio
Source: LPL Research, FactSet 05/09/24
Disclosures: Indexes are unmanaged and not available for direct investment. Past performance is no guarantee of future results.
NNN Class – A triple net lease agreement for real estate in which the tenant promises to pay all expenses such as real estate taxes, building insurance and maintenance.
As highlighted above, specialized real estate investment trusts (REITs) are the best performing subsector within the real estate sector, while industrial REITs are the worst performing. From a valuation perspective, land REITs appear to be the most expensive with a PFFO ratio of 23.5. This compares to the S&P 500 real estate sector average of 16.3. The cheapest subsector within the real estate sector appears to be property management and development with a PFFO of 7.8.
As mentioned above, the shift to more flexible remote work policies has hurt office REITs, with their year-to-date performance declining by more than double digits. Despite their underperformance, office REITs are trading at a relative discount compared to the overall real estate sector, and to subsectors that have benefited from the digital shift, such as data center REITs. You will also notice that infrastructure (towers) and industrial REITs have suffered significant losses this year, despite benefiting from artificial intelligence (AI) (infrastructure, specifically cell towers) and e-commerce (industrials). These two subsectors of real estate rose in tandem with other growth stocks riding the AI and e-commerce megatrends, but have recently fallen as valuations have compressed. Given the outlook for the continued expansion of these megatrends, the outlook for these two subsectors remains promising. Surprisingly, local shopping malls have performed relatively better year-to-date, despite the surge in online shopping.
Outlook
The Strategic and Tactical Asset Allocation Committee (STAAC) remains underweight the real estate sector as commercial real estate continues to face headwinds in a post-COVID world. Additionally, rising interest rates are dampening demand for commercial real estate while inflation remains persistent. While yields and valuations look attractive relative to other asset classes, bonds appear to be a safer bet when it comes to income. STAAC continues to recommend preferred securities among fixed income (the topic of this week's Weekly Market Commentary). Positive factors include an improving technical environment for real estate, with the real estate market broadening and 71% of stocks trading above their 200-day moving averages, tailwinds for data center demand, and downside risk to interest rates if economic growth and inflation slow.