(Bloomberg) — It’s been a challenging couple of years for real estate stocks since the Federal Reserve began raising interest rates in 2022, as borrowing costs soared and the housing market collapsed. And despite a healthy rebound in mid-2024, the outlook for 2025 is not particularly encouraging.
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But that doesn’t mean investors should expect a sea of red in real estate stocks next year. Rather, it will likely be a stock-picking market, where some rise, some fall, and the group doesn’t move in unison, according to Adam White, senior equity analyst at Truist Advisory Services.
That’s not good news for the residential market, which is expected to face challenges from stubbornly high mortgage rates and limited supply in 2025, particularly after comments Wednesday from Fed Chair Jerome Powell indicating that less is coming. rate cuts. Just this week, the average 30-year fixed mortgage rate rose for the first time in a month, Freddie Mac said in a statement Thursday.
But there is growing optimism in one of the hardest-hit corners of the market: office real estate investment trusts.
“Where REITs can really compete is in their cost and availability of capital, and that’s probably most true for offices,” said Uma Moriarity, senior investment strategist at CenterSquare Investment Management. “When you think about a trophy asset in a given market, chances are it’s owned by one of the REITs.”
The group has been hit hard since early 2022, with the S&P Composite 1500 Office REITs index falling more than 30%, while the S&P 500 index gained 24%.
The divergence is not entirely surprising considering the headwinds facing the real estate industry in that stretch. The cost of borrowing soared as the Federal Reserve raised interest rates 11 times between March 2022 and July 2023, the March 2023 regional banking crisis crippled local lenders, and employers struggled to get workers back. to offices after Covid closures.
office bounce
Those pressures have sent real estate stocks tumbling across the board. U.S. REITs have only been as cheap or cheaper relative to the S&P 500 11% of the time over the past 20 years, according to Todd Kellenberger, REIT client portfolio manager at Principal Asset Management. And office REITs are still about 60% below pre-Covid levels compared to the rest of the REIT market, making them a decent target for growth, according to Moriarity.
In many ways, the labor real estate rebound is already beginning. Office REITs have posted a total return, including dividends and share price increases, of more than 28% in 2024, according to data from trade association Nareit, placing them among the group’s best performers after data centers and specialized niche REITs. This is a substantial change from 2023, when office REITs posted a total return of 2%, and 2022, when they fell 38%, Nareit figures show.
The focus on prestige office properties that Moriarity was referring to is also occurring now, as seen in the divergence between high- and low-quality names.
Companies such as SL Green Realty Corp., which focuses exclusively on office buildings in Manhattan, as well as Vornado Realty Trust and Highwoods Properties Inc., which operate in high-end markets across the United States, have seen gains so far this year. year from 30% to more than 50%. Meanwhile, companies like Office Properties Income Trust, which has the federal government as its largest tenant, have plunged about 85% in 2024.
“For the strongest asset portfolios, I wouldn’t be surprised to see another strong year,” Moriarity said.
Trouble in paradise
The outlook is not so optimistic for the residential real estate sector. Homebuilders were the sole beneficiaries of high mortgage rates as they capitalized on a tight resale market and growing demand. But after a dizzying 74% rise since the Federal Reserve began raising rates, the sector is cooling.
The US central bank’s intention to go slower on rate cuts will likely keep mortgage rates higher than expected. And that’s spilling over into dwindling supply as more homeowners are reluctant to move when they’re stuck with an existing mortgage at a significantly lower rate than they can get now.
Homebuilder stocks are on track to finish the year with a 1.6% loss, compared to their 80% jump in 2023. The SPDR S&P Homebuilders ETF is currently seeing its biggest quarterly outflow in two years. And the S&P Composite 1500 Homebuilding Index is down 25% since October 18, putting it in bear market territory.
Even ultra-luxury homes, the part of the residential real estate market that seemed immune to outside forces as deep-pocketed buyers avoided rising borrowing costs by using cash, could be hitting a wall, according to Cole Smead, CEO and portfolio manager. at Smead Capital Management in Phoenix.
“What I dislike the most is high-end luxury real estate,” he said. “It’s going to work terribly.”
Smead expects the stock to mirror the performance of the broader stock market, which he is bearish on through 2025. Luxury homebuilder Toll Brothers Inc., until recently the best-performing homebuilding stock this year, has lost 27% since Nov. 25 and only forecast weaker-than-expected gross margins, underscoring industry concerns about pricing pressure.
The all-cash deals that have kept the market thriving also risk leading to higher borrowing costs. Many of those deals are not done using physical cash, but rather through “money-like” secured lines of credit, Smead said.
“That’s what has been fueling the luxury housing market,” he said. “So what happens if those assets run into difficulties? What will that owner do? Will they sell the titles or will they sell the second or third home? They are going to sell one of the two and that will harm both parties.”
As investors consider how to proceed in the housing market heading into 2025, Truist’s White warns against simply buying a sector fund. Instead, he urges taking a stock-picking approach. Data center REITs, real estate services companies and senior housing REITs are some of the areas where he sees opportunities.
“You’ll want to be more selective,” White said. “It will be more difficult to achieve the same returns in 2025.”
(Adds details about rising mortgage rates in third paragraph)
