Morningstar

Despite Inflation’s Reach, Rising Interest Rates Bring Dose of Reality to Real Estate Sector

We anticipate that interest rate hikes will lead to further performance decline in the sector, in absolute and relative terms to the broader equity markets.

The Morningstar US Real Estate Index is down 25.31% year to date through Dec. 27, 2022, which is worse than the 19.70% decline seen by the broader U.S. equity market over the same period. The real estate sector rose 4.96% in the fourth quarter of 2022, underperforming the broader U.S. equities market that rose 6.91% quarter to date. While the real estate sector has seen negative stock performance over the past 12 months, the sector continues to report strong fundamentals growth with high inflation allowing many real estate subsectors to push rental rate increases that are well above historical averages.

Real Estate Has Declined Slightly More Than the Market

The real estate sector is currently trading significantly below our fair value estimates. The median stock valuation within real estate coverage currently trades at a 25% discount to our estimate of fair value, which is better than many other North American sectors. Currently, 71% of the real estate sector is trading in either the 5-star or 4-star range, 24% is trading in the 3-star range, and only 5% is trading in the 2-star range while no company is currently trading in the 1-star range.

Majority of Real Estate Sector Is Trading at a Discount to Fair Value Estimates

Since 2000, the relative performance of REITs compared with the broader equity market has shown a significant negative relationship to interest rate movements for the 10-year U.S. Treasury.

Relative Performance of REIT Sector Negatively Correlated With Interest Rates

While many income-oriented investors favor REIT investments for their dividend payments during periods of low interest rates, rising rates cause income-oriented incomes to rotate money out of the sector and into lower-risk investments. Additionally, rising interest rates increase the debt costs many REITs rely upon to fund acquisitions and development projects, so external growth becomes less accretive to REIT cash flows as interest rates rise.

Due to the strong negative correlation, rising interest rates in 2022 have directly led to the negative performance of the real estate sector over the past 12 months. We anticipate that interest rate hikes will lead to further declines, in absolute and relative terms to the broader equity markets, for the real estate sector. However, most real estate subsectors should continue to see rate growth, and thus net operating income growth above historical average for the next quarters. Rising interest rates have limited long-term impact on REIT cashflows, so we believe many companies in the sector are trading at a discount due to short-term disruption caused by rising interest rates.

REIT Relative Performance Negatively Correlated With Interest Rates

See our analysts’ Top Picks in the Real Estate Sector.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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About the Author

Kevin Brown, CFA

Senior Equity Analyst
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Kevin Brown, CFA, is a senior equity analyst, AM Financial Services, for Morningstar*. He covers healthcare, hotel, residential, and retail REITs the United States. He has created and maintains financial models for all companies under coverage, focusing on the historical performance and then forecasting the fundamentals to derive a fair value estimate for each company. He has also written multiple thought-leadership reports on the broader REIT sector and the subsectors under his coverage.

Before joining Morningstar in 2018, Brown worked at an asset-management company focused on global real estate, spending nine years covering healthcare and hotel REITs. He developed buy/sell recommendations in each sector to enable portfolio managers to create individualized sector allocations for each client portfolio. He conducted property tours and meetings with company executives and industry experts to evaluate individual company strategies and deepen his understanding of sector fundamentals. Brown was also a board member for the FTSE EPRA/NAREIT North American Advisory Committee between 2008 and 2017.

Brown holds a bachelor’s degree in economics from Dartmouth College. He also holds the Chartered Financial Analyst® designation.

* Morningstar Research Services LLC (“Morningstar”) is a wholly owned subsidiary of Morningstar, Inc

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