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Real estate: Opportunity amid rising rates

Key takeaways

  • The sharp rise in interest rates created significant challenges for REITs in 2022, even as fundamentals such as occupancy rates and income measures remained solid.
  • We anticipate a stabilization in the REIT market in 2023 if interest rates stabilize.
  • One area of potential opportunity may be in residential rentals, given that renting is currently much more affordable than buying in many parts of the country. A particular bright spot: residential REITs in the Sun Belt.

After facing performance headwinds in the past year, real estate investment trusts (REITs) could see some stabilization in 2023 if the pace of interest-rate increases slows. REITs that rent out residential apartments and homes, in particular, could fare strongest given current dynamics in the housing market.

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A challenging past year

In 2022, the most significant force impacting REIT performance was the sharp increase in interest rates. As rates rose, it became more expensive for REITs to take on new debt or roll over existing debt obligations, and more expensive to make potential portfolio acquisitions.

That dynamic triggered a vicious cycle for the sector: Rising financing costs led to lower REIT valuations, which led to still-higher financing costs. The sector is on track to lag the broad market by several percentage points for the year.

Chart shows 2022 year-to-date performance for the real estate sector and for the S&P 500.  As of December 9, real estate sector stocks had lost 23.29% at the index level, compared with the S&P 500's 16.17% loss year-to-date on a total return basis.
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 Dec. 9, 2022. Source: S&P Dow Jones Indices, a division of S&P Global.

Although it might seem surprising, over the long term historically, REIT performance has not generally been dependent on (or correlated to) interest rates. After all, while rising rates do increase financing costs, they're also typically a sign that the economy is strong and unemployment is low, which has historically been a positive for REIT performance. However, during certain shorter-term periods such as what investors saw the past year, interest rates and REIT performance can become linked.

Despite the challenging market backdrop, REITs are still generally showing strong fundamentals—such as occupancy rates and net operating income—even as those fundamentals have somewhat weakened since the peak of the pandemic. As the Federal Reserve has taken aggressive steps to try to tame inflation, however, investors have become more fearful about a slowdown in the asset class.

High ownership costs could benefit residential REITs

For 2023, we're seeing notable potential opportunity among REITs that operate residential rentals.

Demand for housing has been outstripping supply for years. With mortgage rates rising and home prices still high, renting is by far the more affordable option for many people and families. Due to rising rates since the start of 2022, the typical prospective homebuyer's monthly mortgage payment has increased by roughly 60%.1 And the affordability gap between buying and renting a home is historically wide.1

In fact, a median-income household looking to buy a median-priced home could expect to spend between 45% and 50% of their income on their total housing costs—more than double what they would spend on comparable rental housing.1

The segment also has some defensive characteristics that could help it hold up better than some other property types in a rising-rate, weakening economic environment. Compared to other types of REITs, residential REITs tend to carry less debt and are therefore less likely to need to refinance their debt at higher rates in the near term. Further, they can potentially benefit from relatively low-cost debt financing through government-sponsored enterprises Fannie Mae and Freddie Mac.

Bright spots in the Sun Belt

More specifically, we have found potential opportunity in this segment among residential property owners in US Sun-Belt markets, which, compared with urban and northern coastal markets, have benefitted from higher job growth, lower cost of living, and in some cases, tax incentives for corporate relocations. For example, Mid-America Apartment Communities () is a REIT that focuses on ownership, development, and management of apartment communities across the Sun Belt and mid-Atlantic, with complexes from Florida to Nevada.

Of course, apartments aren't the only option for renters. Some REITs focus on renting out single-family homes instead. For example, Invitation Homes () is a Dallas-based owner of single-family rental homes. Renting a single-family home is generally more affordable than owning in the Dallas area. Renters of single-family homes tend to have longer average stays than apartment renters, and that lower turnover typically means reduced repair and maintenance costs for owners. What's more, today's apartment renters could someday move on to renting single-family homes, which would support the business of single-family home rentals.

Fund top holdings*

Top-10 holdings of the Fidelity® Real Estate Investment Portfolio () as of October 31, 2022:

  • 10.0% – Prologis Inc. ()
  • 9.2% – Crown Castle Inc. ()
  • 7.0% – SBA Communications Corp. ()
  • 5.1% – Equinix Inc. ()
  • 4.5% – Welltower ()
  • 4.1% – Digital Realty Trust Inc. ()
  • 3.9% – Extra Space Storage Inc. ()
  • 3.8% – Ventas Inc. ()
  • 3.6% – UDR Inc. ()
  • 3.6% – Mid-America Apartment Communities Inc. ()

(See the most recent fund information.)

Cautious optimism for 2023

After a difficult past year, we're optimistically awaiting the possibility of a stabilization in the REIT market and in interest rates in the coming year. At the same time, we're seeking REITs with defensive characteristics and better relative fundamentals that could hold up strongest in the face of continued challenges.

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Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully. 1. John Pawlowski, Alan Peterson, and Robyn Luu, "Residential Insights: Facing the Music," Green Street Advisors, October 24, 2022. * Any holdings, asset allocation, diversification breakdowns or other composition data shown are as of the date indicated and are subject to change at any time. They may not be representative of the fund's current or future investments. The Top Ten holdings do not include money market instruments or futures contracts, if any. Depository receipts are normally combined with the underlying security. Some breakdowns may be intentionally limited to a particular asset class or other subset of the fund's entire portfolio, particularly in multi-asset class funds where the attributes of the equity and fixed income portions are different. Under the asset allocation section, international (or foreign) assets may be reported differently depending on how an investment option reports its holdings. Some do not report international (or foreign) holdings here, but instead report them in a "Regional Diversification" section. Some report them in this section in addition to the equity, bond and other allocation shown. Others report international (or foreign) holding as a subset of the equity and bond allocations shown. If the allocation without the foreign component equals (or rounds to) 100%, then international (or foreign) is a subset of the equity and bond percentage shown.

Views expressed are as of the date indicated, based on the information available at that time, and may change based on market or other conditions. Unless otherwise noted, the opinions provided are those of the speaker or author and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information.

References to specific securities or investment themes are for illustrative purposes only and should not be construed as recommendations or investment advice. This information must not be relied upon in making any investment decision. Fidelity cannot be held responsible for any type of loss incurred by applying any of the information presented. These views must not be relied upon as an indication of trading intent of any Fidelity fund or Fidelity advisor. Investment decisions should be based on an individual's own goals, time horizon, and tolerance for risk. This piece may contain assumptions that are "forward-looking statements," which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Past performance is no guarantee of future results.

Investing involves risk, including risk of loss.

Stock markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. Because of its narrow focus, sector investing tends to be more volatile than investments that diversify across many sectors and companies. Sector investing is also subject to the additional risks associated with its particular industry.

Changes in real estate values or economic conditions can have a positive or negative effect on issuers in the real estate industry.

The S&P 500® Index is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent US equity performance. The S&P Real Estate Select Sector index comprises those companies included in the S&P 500 that are classified as members of the real estate sector, with capping applied to ensure diversification among companies within the index.

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