(Bloomberg) — It’s been a challenging few years for real estate stocks since the Federal Reserve began raising interest rates in 2022 as borrowing costs soared and the real estate market collapsed. And despite a healthy recovery in mid-2024, the outlook for 2025 is not particularly encouraging.
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But that doesn’t mean investors can expect a sea of red in real estate stocks next year. It’s more likely to be a stock market, where some rise, some fall, and the group doesn’t move in unison, said Adam White, senior equity analyst at Truist Advisory Services.
That’s not good news for the housing market, which is expected to face challenges from stubbornly high mortgage rates and limited supply through 2025, especially after Fed Chairman Jerome Powell indicated in comments on Wednesday that fewer rate cuts are on the way are. 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 most deteriorated corners of the market: office real estate mutual funds.
“Where REITs can really compete is in the cost and availability of capital, and that’s probably most true for offices,” said Uma Moriarity, senior investment strategist at CenterSquare Investment Management. “If you think about a trophy in a particular market, it’s more likely to be owned by one of the REITs.”
The group has been hit hard since early 2022, with the S&P Composite 1500 Office REITs Index plunging more than 30% while the S&P 500 Index rose 24%.
The difference isn’t entirely shocking given the headwinds the real estate sector is facing during that period. Borrowing costs soared as the Fed raised rates 11 times between March 2022 and July 2023, the March 2023 regional banking crisis crippled local lenders and employers struggled to bring workers back to their offices after Covid lockdowns.
Office rebound
These pressures have driven real estate stocks lower across the board. According to Todd Kellenberger, REIT client portfolio manager at Principal Asset Management, U.S. REITs have been as cheap or cheaper compared to the S&P 500 only 11% of the time over the past two decades. And office REITs are still down about 60% versus from pre-coronavirus levels compared to the rest of the REIT market, making them a decent target for growth, according to Moriarity.
In many ways, the recovery of workplace real estate has already begun. Office REITs have achieved a total return, including dividends and share price increases, of more than 28% in 2024, according to data from industry association Nareit, making them among the best performing in the group after data centers and niche specialist REITs. That’s a substantial turnaround from 2023, when office REITs posted a total return of 2%, and 2022, when they fell 38%, Nareit figures show.
The focus on prestigious office properties that Moriarity referred to is also happening now, as evidenced by the difference between high and lower quality names.
Companies like SL Green Realty Corp., which focuses exclusively on Manhattan office buildings, and Vornado Realty Trust and Highwoods Properties Inc., which operate in high-end U.S. markets, have posted gains of 30% so far this year to more than 50%. Meanwhile, companies like Office Properties Income Trust, which has the federal government as its largest tenant, are down about 85% through 2024.
“For the portfolios with the strongest assets, I wouldn’t be surprised if we see another strong year,” Moriarity said.
Trouble in paradise
The outlook is not nearly as optimistic for residential real estate. Homebuilders were the unique beneficiaries of higher mortgage rates, as builders benefited from a tight resale market and rising demand. But after a blistering 74% increase since the Fed started raising rates, the sector is cooling off.
The US central bank’s intention to slow down in interest rate cuts will likely keep mortgage rates higher than expected. And that translates into declining supply, as more homeowners are reluctant to move if they’re tied to an existing mortgage at a significantly lower rate than they can get now.
Homebuilder stocks are on track to end the year with a loss of 1.6%, compared to their 80% jump in 2023. The SPDR S&P Homebuilders ETF is currently seeing its largest 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 impervious to outside forces as deep-pocketed buyers avoided rising borrowing costs by turning to cash, could hit a wall, said Cole Smead, CEO and portfolio manager. at Smead Capital Management in Phoenix.
“The thing I’m most negative about is high-end luxury real estate,” he said. “It’s going to happen terribly.”
Smead expects the shares 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 homebuilder stock this year, has lost 27% since Nov. 25 and forecast only weaker gross margins than expected, underscoring industry concerns about price pressures.
The all-cash deals that have kept the market buoyant are also at risk of higher financing costs. Many of these deals are not done with physical cash, but rather through “cash-like” collateralized lines of credit, Smead said.
“That’s what fuels the luxury home market,” he said. “So, what if those assets are struggling? What is that owner going to do? Will they sell the securities, or will they sell the second or third house? They are going to sell one of the two, and that will hurt both parties.”
As investors consider how to play the real estate market heading into 2025, Truist’s White warns against simply buying a sector fund. Instead, he insists on a stock selection approach. Data center REITs, real estate services companies and senior housing REITs are some areas where he sees opportunity.
“You’re going to 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)
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