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.

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.

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.

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.