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By Adam Day, Financial Advisor
The stage is set for the Federal Reserve to begin lowering the federal funds rate potentially.
Lower interest rates may impact the real estate sector positively. The “locked in” factor may continue because the average rate on active mortgages is below 4%.
Investing in real estate through Real Estate Investment Trusts (REITs) may be more advantageous for investors looking to be more hands-off. Not all real estate investments are created equal and buying this sector passively or on the broad market may be a mistake for investors.
Federal Reserve sends message of rate reduction
Last month the Federal Reserve held their annual Jackson Hole, Wyoming meeting. Other than the talking heads within the financial sector playing cowboy for a week and dressing like the cast of Yellowstone, the main takeaway was that the Federal Reserve is set to cut interest rates soon.
“The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.” - Jerome Powell, Federal Reserve Chairman
With this, financial markets continued to rally out of the sharp sell-off that kicked off in August. Investors now face questions moving forward:
How quickly do rates go down and how far do they fall?
The answer to these questions are somewhat a….wait and see.
For rates to be cut rapidly and deeply, there would need to be economic data to support that type of movement. In general, this would not be great for overall economic expansion, GDP, and likely financial markets. Most investors would not root for quick and deep rate cuts. However, slow and steady cuts supported by decent economic data would be, likely, welcomed.
What does that mean for different sectors of the economy?
This is somewhat rhetorical. It’s different for different sectors of the economy.
The real estate sector is an area that all investors are a participant in one form or another. It’s also the sector that has struggled the most with the higher interest rate environment for the last two years.
Real estate as an economic sector has a few components:
Residential: The most obvious component. Single and multifamily homes.
Commercial: Real estate that is used for business purposes. Malls, shopping centers, office space and hotels.
Industrial: Properties that are used for manufacturing and production. Factories, power plants, cell phone towers, etc.
Within all of these sub-sectors, there are many drivers of prices and the affordability factor. Some examples:
Residential: Ratio of buyers to sellers, location, interest rates, etc.
Commercial: All of the above, plus secular trends like company policies for work-at-home in the Covid-era killed a lot of demand for office space.
Industrial: Cities that have had a large influx of people may have more demand on their infrastructure like power plants.
In addition to some of the above, market-driven factors, interest rates are a large component of the affordability factor. For example, let's take on a real-world scenario of what we have seen over the last few years.
Affordability of a new home purchase based on mortgage rates
Let’s use a residential transaction for this test, with a price of $440,000, which is very close to the national average, according to RedFin.
The only thing we will change in this scenario comparison is the mortgage interest rate to compare affordability.
3.0% Mortgage | 7.5% Mortgage | |
Home price | $440,000 | $440,000 |
Down payment | 20% ($88,000) | 20% ($88,000) |
Mortgage | $352,000 @ 3% for 30 years | $352,000 @ 7.5% for 30 years |
Monthly Payment | $1,496.56 | $2,483.68 |
The payment difference between the two scenarios is significant, which would have boxed out many buyers from qualifying or affording to purchase. In addition, this is almost the same movement that we have seen in mortgage rates from the beginning of 2022 to today (as of 9/5/24).
While this is a residential example its application works for both, commercial and industrial. Although the underlying loan structures and processes are different, the moral of the story is that lower rates, given a healthy buyer pool and inventory, would likely lead to more transactions than a higher-rate environment.
How to invest in real estate
There are two main ways to invest in real estate, direct and indirect.
A direct example would be purchasing a single-family home on a university campus to rent out to college students. This usually means that you are the owner of the property or have a mortgage and are responsible for collecting rent, maintaining the property, paying property taxes, etc. Some will use a property management company for a fee to help mitigate some of these tasks, but the buck stops with the investor/owner. Usually, this equates to a part-time job or sometimes more.
An indirect example would be utilizing a Real Estate Investment Trust otherwise known as a REIT. Think of this as a collection of investors that pool their money together to buy one piece of real estate or many pieces of real estate. It is much more hands-off for the investor. Another advantage of this is diversification.
Pooling of investors to create a REIT
Investors pool money together with other investors so they can buy multiple pieces of property in different locations, sub-sectors, industries, price points, etc.
Another advantage that most investors like is that they often pay out a good portion of their earnings in dividends. You could compare it to owning a property directly and collecting income. Lastly, depending on the structure, REITs are generally more liquid than direct ownership.
There are many ways to invest in REITs including:
REITS that trade publicly
Mutual funds and exchange-traded funds that buy REITs
Private REITs
Underlying holdings of a REIT is important
One of the most important factors that investors should be aware of is what the underlying holdings are within the REIT or REIT fund’s portfolio.
When most investors think about investing in real estate, the most obvious products are houses, warehouses, office space, and retail space. However, many sub-sectors may be overlooked. If you look at the sector as a whole, it looks like this (as of 9/5/24):
Telecom Tower REITs 12.7%
Retail REITs 12.1%
Industrial REITs 12.1%
Health Care REITs 11.1%
Data Center REITs 9.2%
Multi-Family Residential REITs 8.8%
Self-Storage REITs 7.6%
Other Specialized REITs 6.7%
Real Estate Services 6.5%
Single-Family Residential REITs 4.6%
Mortgage REITs 2.3%
Office REITs 2.3%
Timber REITs 2.1%
Diversified REITs 0.9%
Hotel & Resort REITs 0.9%
Real Estate Development 0.2%
In short, a REIT is only as good as its underlying holdings and buying this sector passively or on the broad market may be a mistake for investors.
Even in a declining rate environment, some home buyers contend with the "locked in" factor
If interest rates went lower there is likely a larger buyer pool for those looking, but have been boxed out by the current interest rate environment.
However, this may be a bit of a double-edged sword. If the buyer pool increases, that means demand is going up, which may make prices increase from their current stagnation in the single-family real estate market. In addition to that, across the United States, there is still a severe undersupply of houses compared to the population's needs.
For existing homes with mortgages, sale probability decreased by 18% for every 1% above the existing mortgage origination rate that the current market rates were.
Another factor that may add hindrance to buyers even in a declining rate and environment is called the “locked in” factor. For existing homes with mortgages, sale probability decreased by 18% for every 1% above the existing mortgage origination rate that the current market rates were," according to research published earlier this year by the Federal Housing Finance Agency.
The “locked in” factor may continue because the average rate on active mortgages is below 4%. With this, there may still be room for price growth, but buyers and investors looking to purchase may still be sidelined unless there is a large move in interest rates.
Investors surprised by how small office space portion is in real estate sector
Many have a recency bias with the Covid-era and how much rhetoric there was on office space, work from home and the future outlook of office culture. However, not all offices are created equally.
30% of existing office buildings comprise more than 90% of total vacancies on the market, according to JLL Research.
By contrast, 40% of buildings have no vacant space at all, indicating a widening separation between winners and losing.
What type of office properties are in demand?
Buildings developed in 2015 and after. There is strong demand as evidenced by positive net absorptions that are approaching 115 million square feet.
Data centers: Artificial intelligence cloud computing, streaming, social media, and gaming are significant shifts that are already driving demand. Data centers are seeing rental growth on average around 20 percent and very low vacancy rates. Demand is so high already in a high interest-rate environment, as long as demand continues, growth will likely continue.
Industrial: Part of the thesis for industrial is twofold. The first thesis plays off the data center story and is a larger secular trend. With things like artificial intelligence, data usage, and cloud computing the world doesn’t seem to be getting any less attached to technology. Technology uses energy, and artificial intelligence uses significantly more energy, according to NPR. Therefore, the infrastructure for energy needs to be in place to meet demand.
Power plants, oil and gas facilities, etc. The second case for industrial is more geopolitical. In the post-Covid era, companies have been significantly rethinking repatriation of their supply chains and manufacturing. The world watched as the supply chain pileup happened during 2020 and 2021 with offshore supply lines. In addition, the geological temperature internationally seems to be getting warmer. Other countries are jockeying for the lead position in maritime security with some companies looking to mitigate that risk by bringing jobs and manufacturing back to the United States.
There are three reasons to invest in REITS as part of an investor's portfolio, according to Cohen and Steers.
REIT valuations vs. equities are meaningfully below the historical median.
REITS have historically performed well following the end of Federal Reserve rate hikes.
In summary, interest rates play a crucial role in shaping the real estate market by influencing affordability, demand, property values, and investment strategies. Higher interest rates typically lead to decreased demand, slower price appreciation, and a more cautious approach from both, buyers and investors. Lower rates generally stimulate the market, encouraging more activities in home buying, selling, and investment.
Please consult with your financial advisor about your own specific investment objectives, tolerance for risk, and if REITs should be incorporated into your investment plan.