Key Takeaways
- Rising interest rates weighed on the real estate sector for the second year in a row in 2023.
- Although the higher cost of borrowing was a headwind, many segments of real estate investment trusts (REITs) continued to show strong fundamentals and supply-demand dynamics.
- 2024 could be a calmer year if interest rates level off and the pace of commercial real estate transactions normalizes.
- Fidelity real estate portfolio managers Steve Buller and Sam Wald have found particular opportunity recently among shopping-center REITs. Data centers, senior housing, and manufactured housing have been other recent areas of interest.
While the rapid pace of interest-rate hikes over the past 2 years has impacted all sectors, it may have been felt most acutely in the real estate sector. Higher interest rates have meant a higher cost of borrowing for real estate investment trusts (REITs), which has created performance headwinds for 2 straight years.
But with the Fed signaling a potential pause on rate hikes, the time for a recovery in REITs may finally be near. And if investors look beyond negative headlines on interest rates and empty office buildings, there are actually plenty of opportunities with strong fundamentals to be found.
2023: A sideways year
For the second consecutive year, rising borrowing costs were the most significant factor impacting REITs in 2023. The overall volume of purchases and sales remained low due to high interest rates and scarce capital. Negative headlines about empty downtown office spaces—stemming from the shift to remote work—may also have impacted investor sentiment. Altogether, these drivers contributed to a sideways performance year.
Past performance is no guarantee of future results. Real estate sector performance is represented by the S&P Real Estate Select Sector index. Data as of December 8, 2023. Source: S&P Dow Jones Indices, a division of S&P Global.
Yet despite these challenges, many REITs continued to show strong fundamentals, driven by increased rental income. Commercial real estate supply-and-demand dynamics remained generally favorable in 2023. Moreover, in most parts of the real estate market, REITs' balance sheets remained well positioned to weather the current market environment.
2024: Awaiting normalization, and shopping for opportunities
We believe 2024 could bring calmer seas for the sector if interest rates level off and commercial real estate transaction volume gradually normalizes.
One top recent area of interest to us has been retail shopping-center REITs. Although we've long avoided mall REITs due to the industry's long-term headwinds, we see shopping centers as a more compelling category.
Malls tend to be destinations for shopping for "wants," such as clothing and luxury items, which consumers may cut back on in a pinch. But shopping centers tend to be destinations for meeting "needs," such as buying groceries and filling prescriptions—items that consumers are likely to continue to spend on even when times become tight. With household credit quality weakening under high interest rates, budget-conscious consumers have been gravitating to shopping centers. Furthermore, changing lifestyles driven by remote and hybrid work have benefited shopping centers, as these properties are often located nearer to people's homes.
Favorable supply-and-demand dynamics have also benefitted shopping centers—which lease their space to commercial and retail tenants. On the demand side, retailers have proved surprisingly eager to open new stores. In terms of supply, new property development has been scarce due to the lack of construction lending, limited available land, and other forces. In 2023, available retail space fell to its lowest level in at least 18 years.1 This has given property owners increased bargaining power, and allowed them to push through big increases in asking rents—benefitting their bottom lines. We've favored shopping-center REITs with strong fundamentals such as those benefitting from strong occupancies and robust rental-rate growth potential.
Opportunities in data centers, senior housing, and more
Elsewhere in the REITs universe, a number of subsectors have shown promising long-term growth potential.
Data centers—where cloud providers turn to meet their massive storage needs—are one such area. The rise of artificial intelligence is accelerating the demand for these interconnection sites, which benefit from restricted supply and strong pricing power. Another theme that could have legs is health care real estate—particularly senior housing, which could enjoy a potential tailwind from demographics. A rapidly aging population in the US and some other developed nations should support demand for quality assisted living and memory-care facilities. These facilities generally cater to older individuals who can afford to pay rent out-of-pocket for their rooms.
Finally, the nationwide shortage of affordable housing has created opportunity in the lower-cost manufactured-housing market. This sector includes RV resorts and mobile-home communities, including ones aimed at retirees. These business models can offer particularly favorable economics, since the owner/operator simply owns the land under the homes, collects rent, and doesn't need to invest much.
Practicing patience
After a volatile couple of years, we're optimistic about the potential for a calmer year in 2024. Given the strong fundamentals and compelling long-term drivers among certain REIT subsectors, we think the coming year could be constructive for patient real-estate investors.