(Bloomberg) — It's been a challenging two years for real estate stocks since the Federal Reserve began raising interest rates in 2022, as borrowing costs rose and the property 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 shares next year. Instead, it is likely to be a bullish market, where some rise, some fall, and the group does not move in unison, according to Adam White, senior equity analyst at Advisory Services for Trinians.
That's not great news for the housing market, which is expected to face challenges from stubbornly high mortgage rates and limited supply in 2025, especially after Fed Chairman Jerome Powell's comments on Wednesday indicating fewer rate cuts is coming 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 beaten 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 about jobs,” said Uma Moriarity, senior investment strategist at CenterSquare Investment Management. “When you think of a pretty asset in any given market, more likely than not, it's owned by one of the REITs.”
The group has been hit hard since the start of 2022, with the S&P Composite 1500 Office REITs Index plunging more than 30% while the S&P 500 Index has gained 24%.
The difference is not entirely surprising given the headwinds facing the real estate industry during that period. The cost of borrowing increased as the Fed raised interest rates 11 times between March 2022 and July 2023, the regional banking crisis in March 2023 gripped local lenders, and employers struggled to get workers to return to offices after Covid lockdown.
Office Bounce
Those pressures have reduced real estate stocks across the board. US REITs have only been 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 down about 60% from pre-Covid levels compared to the rest of the REIT market, making them a worthy target for growth, according to Moriarity.
In many ways, the rebound in workplace real estate is already beginning. Office REITs have posted total returns, which include dividends and share price appreciation, of more than 28% in 2024, according to data from trade association Nareit, putting them among the best performers in the group after data centers and specialty specialty REITs. That's a significant turnaround from 2023, when office REITs posted total returns of 2%, and 2022, when they fell 38%, according to Nareit figures.
The focus is on prestigious office properties Moriarity is also happening now, as seen in the difference between high quality and lower 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 U.S., have seen gains from a year ago. 30% to more than 50%. Meanwhile companies such as Office Properties Income Trust, which has the federal government as its largest tenant, have plunged around 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 nearly as optimistic for residential real estate. Homebuilders were unique beneficiaries of high mortgage rates as builders took advantage of a tight resale market and rising demand. But after a massive 74% rally since the Fed started raising rates, the sector is cooling off.
The US central bank's intention to go slower on rate cuts will likely keep mortgage rates higher than anticipated. And that spills over into dwindling supply as more homeowners are reluctant to move when they're locked into an existing mortgage at a significantly lower rate than they can currently get.
Homebuilder stocks are on pace to end 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 impervious to external forces as deep-pocketed buyers avoided rising borrowing costs by using cash, could be hitting a wall, according to Cole Smead, chief executive officer 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 do terribly.”
Smead expects the shares to mirror the performance of the broader stock market, which he predicts for 2025. Luxury homebuilder Toll Brothers Inc., until recently the best-performing homebuilding stock this year, has lost 27% since November 25 and just forecast a weaker-than-expected gross margin, underscoring industry concerns about pricing pressures.
The cash deals that have kept the market thriving are also at risk from higher borrowing costs. Many of those deals are not done using physical cash, but rather through “cash-like” collateral lines of credit, Smead said.
“That's what's been feeding the luxury home market,” he said. “So what if those assets are struggling? What will that owner do? Will they sell the securities, or will they sell the second or third home? They're going to sell one of the two, and it's going to hurt both sides.”
As investors consider how to play the real estate market heading into 2025, Truist's White warns against buying a sector-only fund. Instead, he encourages taking a stock picker approach. Data center REITs, real estate services companies and senior housing REITs are some areas where he sees opportunities.
“You're going to want to be more selective,” White said. “It's going to be harder to make the same gains in 2025.”
(Adds details on rising mortgage rates in third paragraph)
