After years of bleak numbers amid a recession and housing bust, the U.S. real estate market finally seems to have regained its health. Residential housing recently posted its best year-over-year price gains since 2006,1 and some of the hardest-hit markets, such as Phoenix and Las Vegas, have seen prices jump by double digits. In the commercial market, rents and occupancy rates are moving higher, and demand is outstripping supply.2
But will the recovery last, and how might investors think about taking advantage of it—or are they already too late? A few Fidelity portfolio managers think the fundamentals are in place for a sustained recovery, and share some ideas on where they are looking for opportunities, including in home building, related industries, and real estate investment trusts (REITs).
Distinct factors are powering the recovery in residential and commercial real estate. Holger Boerner, manager of Fidelity® Select Portfolios® Construction & Housing Portfolio, says the residential recovery could have staying power, driven by a supply and demand imbalance. According to Boerner, homebuyers largely stopped buying during the worst of the downturn, leading to pent-up demand. These house shoppers are finally reentering the market. “After five years of forgoing a move, people are saying enough is enough,” he says.
Meanwhile, supply has tightened: There were more than 10 months’ worth of existing home sales available in 2008, according to the National Association of Home Builders. In 2012, supply fell to just 5.9 months’ worth of inventory, and during the first four months of 2013 that number declined further to less than 5 months. The result in some markets is heated competition for properties and higher sales prices.
Home buying also has become more appealing compared with renting: Interest rates have recently begun to move up, but remain near historic lows, with 30-year fixed rates in the near 4% range as of June 13, 2013, while rents have risen as much as 25% in many markets over the last three years. “All of a sudden, you might be able to move into a single-family home and pay less than what you’re paying for your apartment,” notes Boerner. “That’s pretty attractive.”
On the commercial real estate side, gradual improvements in occupancy and rental rates have been helping property owners generate stronger cash flows. And even though a sluggish economy has been holding back job growth—historically a primary driver of expansion in the commercial market—demand has still exceeded supply for the majority of commercial property types and sectors.
“The supply and demand dynamic for commercial property seems fairly predictable over the next couple of years, and there are generally good fundamentals,” says Mark Snyderman, manager of Fidelity® Real Estate Income Fund. “It’s hard to see that changing, absent a big recession.”
Riding the housing rebound
Boerner notes that demand for new housing has driven much of the recovery in the residential market. Builders of single-family homes offer a clear way to play this trend, he says. He acknowledges that this group’s stock prices have risen roughly 80% in the last year, but thinks there may be potential for continued upside: Housing starts are expected to rise from an annualized rate of about 1 million in March 2013 to between 1.3 and 1.4 million in 2015. “I think the number may be higher than expected, and I think that should be a positive driver for homebuilders to exceed earnings expectations,” he says.
Boerner also notes that home improvement retailers such as Home Depot and Lowe’s may be poised to benefit from an uptick in remodeling and other home improvements.3 “These retailers have done a great job in taking costs out of their business and growing market share in the down cycle,” he says.
Sonu Kalra, manager of Fidelity® Blue Chip Growth Fund, adds that the growth in new housing stock and the uptick in remodeling also should benefit a wide range of other companies, from paint manufacturers to faucet makers. He notes that appliance maker Whirlpool generated roughly 25% of its revenues as a result of new home construction at its peak.4 That number has fallen to about 10% of revenue, and the company in recent years has streamlined its operations. “This means there is room for that part of their business to grow, and we could see some nice profitability if sales volume recovers,” he says.
A recovery in the housing market can produce a deep ripple effect for spending, Kalra observes, benefiting companies from banks, which benefit from higher loan volumes and stronger mortgage assets, to automobile companies selling more pickup trucks to builders. “Pickups are the highest-profit vehicle auto manufacturers sell,” he says. “And when contractors feel better about their business, they go out and buy a new pickup.”
Investors in the commercial real estate market need to consider lease length: Rents have been rising steadily in recent years, and the properties with the shortest lease terms have been the first to benefit.
Steve Buller, manager of Fidelity® Real Estate Investment Portfolio, says the properties with the shortest lease rates are hotels, which can take advantage of higher room rates on an almost daily basis. “Hotels have done spectacularly well on the ground,” he says. “Rates have improved quite a bit over the last year or two, as have occupancy rates.”
Snyderman of Fidelity Real Estate Income adds that apartments are the next commercial properties that can take advantage of higher lease rates. Industrial properties such as warehouses may take several years to benefit from improving rate trends due to some oversupply going into the recession.
That said, industrial properties are enjoying a pickup in demand. Buller notes that many are benefiting from growth in the e-commerce sector. “Any time a good is not bought in a store, it’s distributed through a warehouse,” he says. “So we’re seeing incremental demand shifting from retail space to industrial real estate.”
Buller also is bullish on the high-quality mall sector. For example, Simon Property Group owns large-scale retail properties with relatively high sales per square foot. Buller says few malls are being built these days, leading to a lack of competitive supply.5 “It’s very difficult to get zoned,” he says. “You also need anchor stores, and Macy’s, Nordstrom, JC Penney, and Sears aren’t exactly in expansion mode. In the next five years, there are probably going to be two new malls built, while historically a minimum of two to five malls were built and delivered every year.”
Using REITs to invest
The reality of nontraded REITs
- Investors increasingly have been drawn to nontraded REITs in recent years. These investments don’t trade on an exchange, so they are free from the day-to-day volatility traditional REITs might experience. Of course, this lack of volatility is not because these instruments are less risky or have less movement in underlying values than traded REITs—it’s because the price is only determined when needed for a transaction or liquidity event. But this perceived lack of volatility, coupled with the promise of relatively high yields, has led many investors to seek out nontraded REITs through brokerage houses and other institutions.
- These investments come with major strings attached, however. For starters, nontraded REITs generally charge high fees. They offer very limited liquidity as well: There’s no market to trade shares, so investors typically must hold on to their investment until a liquidity event, such as a public offering or sale of the assets. And liquidity events don’t always work out well for investors. “In the majority of instances, significant capital losses have occurred,” notes Buller.
In some cases, investors aren’t getting the whole truth about these investments. Wall Street watchdog FINRA recently warned brokerages that they need to do a better job outlining the potential risks of nontraded REITs in their sales pitches to investors. For investors considering this option, the lesson is clear: Make sure you weigh any potential benefits from nontraded REITs against their substantial risks.
Learn more: Read "Non-traded REITs: What you need to know"
REITs—companies that own properties and distribute most of their cash flow to shareholders—may offer an attractive way to invest in commercial real estate. Buller notes that REITs’ valuations are near historical highs, but he thinks that the yields may still be attractive for income-seeking investors.
REIT dividend yields today stand at about 3.9%—roughly double the yield of the 10-year Treasury, but well below the long-term average.6 While REITs and Treasuries have different risk levels and tax treatments and should not be considered interchangeable, the yield spread could be helpful in understanding how expensive the income from REITs is on a relative basis. The 170-basis-point yield spread between REITs and the 10-year Treasury is well above the typical 100-point spread, according to Buller. “You could argue—and I don’t dispute it—that REITs can be viewed as expensive,” he says. “But from an income standpoint, valuations are not extreme.”
In the bond market, Snyderman points out that issuance of commercial mortgage-backed securities has come back to a healthy level. “It’s not close to the level of issuance in the boom years of 2005, 2006, and 2007, but it’s become a reasonably active market,” he says.
He recently has not been finding compelling opportunities in agency mortgage-backed securities. “Agency-backed paper doesn’t have significant yield,” says Snyderman. “We’re more focused on finding situations in which we can understand the credit and the value of the real estate, and figure out we have a margin of safety and can get paid for it. That’s not the case for agency mortgage-backed securities.”
The bottom line
Rising interest rates present the greatest risk to residential real estate. A sharp uptick in rates could mute the recovery in the residential markets, or even cause another downturn, though such a scenario appears unlikely in the near term, according to the Fidelity managers. On the commercial side, an influx of supply might be the biggest risk, but for now the market’s improving fundamentals appear sustainable, and may make real estate worth considering as part of a diversified portfolio during the coming years.
- Holger Boerner manages Fidelity® Select Portfolios® Construction and Housing Portfolio (FSHOX)
- Steve Buller manages Fidelity® Real Estate Investment Portfolio (FRESX)
- Mark Snyderman manages Fidelity® Real Estate Income Fund (FRIFX)
- Sonu Kalra manages Fidelity® Blue Chip Growth Fund (FBGRX)
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- Find REITs, MBS, and housing stocks in our research center