Real estate sector

Like many other non-tech-focused sectors, real estate had a bumpy year in 2024 as investors concentrated their attention on mega-cap growth stocks.

For 2025, we are cautiously optimistic about the prospects for the sector as a whole. Industry fundamentals look to be bottoming out, which could pave the way for improvement. And borrowing costs look likely to potentially decline. But we are particularly excited about the prospects of one industry segment: the data centers that power in-demand artificial intelligence (AI) models.

2024: Benefitting from the broadening

The real estate sector is primarily composed of real estate investment trusts, or REITs. These are companies that own, operate, or finance properties across a diverse mix of sectors including offices and cell towers, apartment buildings, warehouses, retail and data centers, health care, and self-storage facilities.

REITs lagged in the first half of 2024 as market gains were dominated by a narrow group of mega-cap stocks in the information technology and communication services sectors—particularly companies deemed to be at the forefront of the AI race.

Then around the middle of the year the market started broadening, driven by concerns about valuations in the tech sector and growing confidence that interest-rate cuts were on the way. This allowed a wider range of stocks to start participating in gains and provided more favorable conditions for REIT investors.

The sector then gave back some of those gains in the latter months of the year, as long-term interest rates and growth stocks started to surge again. In all, 2024 may go down as a positive, but lagging, year for the real estate sector.

2025: Potential improvements in rates and fundamentals

Any declines in interest rates could be a positive development for the asset class in 2025. REITs are highly capital intensive, meaning they benefit from the availability and affordability of financing. While the Fed is widely expected to reduce the fed funds rate further in 2025, the real estate sector is more influenced by longer-term interest rates, which have generally risen since the Fed started cutting its benchmark rate. If long-term rates continue to increase or stay high, REITs may see less of a benefit.

From a supply-demand perspective, real estate fundamentals appear to be bottoming out. For example, certain segments had until recently been suffering from supply-demand imbalances, with excess supply that needed to be absorbed. Those segments have included sunbelt apartments, industrial properties, and self-storage facilities. Resolving these imbalances could create opportunities for potential improvement next year.

One cautionary note about performance over the next 12 months is that valuations in the sector have recently been slightly high.

Seeking in-demand property segments

Against this potentially more favorable backdrop for REITs, we’ve been witnessing compelling long-term tailwinds in various market segments.

For instance, health care properties have looked appealing recently, due to the rising demand for senior housing facilities created by an aging population. Another in-demand segment has been industrial REITs, which have been benefiting from ongoing growth in e-commerce. As retailers need to store and transport more items to customers’ homes and businesses, the demand for specialized logistics facilities has grown.

However, the segment we’re perhaps most excited about for 2025 is data-center REITs. For much of 2024, stock investors primarily focused their AI enthusiasm on the technology sector. As the year progressed, this enthusiasm spread to other parts of the market offering better valuations, including data centers, which store the servers that power AI applications. The AI boom has fueled a surge in demand for data centers, while the supply of these specialized facilities is constrained, creating significant pricing power for their owners.

An insatiable need for data and servers

One reason for the rapid growth in demand for data centers is the extensive resources required to run and train AI models. To reach its full potential, AI requires substantial technological infrastructure, and data centers play a central role in meeting these requirements.

While the demand for data centers has skyrocketed, the supply of these crucial facilities has struggled to keep pace. One significant constraint is the availability of power—data centers need a lot of it to operate. Another is the requirement for ready access to water, needed to keep servers from overheating. Finally, aesthetic and noise concerns mean that many people object to living near data centers, which has created obstacles on the ground to building new properties.

These factors collectively have hindered the construction of new data centers. Coupled with the strong demand, they have created an environment in which data-center REITs have been able to raise rents over time.

In seeking data-center industry investments, we’ve prioritized REITs that operate in desirable locations close to their customers. Proximity is critical for customers seeking to enhance their connection speeds, and many customers have proved willing to pay higher rents for the opportunity. We’ve also prioritized data centers with stronger financial positions and greater access to capital, which could see a particular benefit from cheaper financing if long-term interest rates fall.

Monitoring the industry

We’re optimistic about the opportunity for REITs in 2025, thanks to favorable supply-demand dynamics and potential improvements in financing costs. Data-center owners have looked particularly appealing, as the AI boom and supply constraints have provided a tailwind for the industry. We’ll aim to monitor market conditions in the coming year, particularly valuations, and aim to adjust our positioning as the backdrop develops.