In recent months, Real Estate Investment Trusts (REITs) have shown a strong recovery. From July 1 to August 16, 2024, the S&P 500 Real Estate Index rose 9.9%, outperforming the gain of 1.4%.
Market expectations of a change in the Federal Reserve’s (Fed) interest rate policy have largely driven this rally. REITs are typically affected by changes in interest rates due to their dependence on external financing.
Despite this positive performance, Wells Fargo analysts remain cautious about the real estate sector and have a negative view on REITs.
Wells Fargo’s cautious stance toward REITs and the broader real estate industry has been in place for several years.
Since March 2022, analysts have consistently rated the S&P 500 real estate sector unfavorably compared to other S&P 500 sectors. Even with the recent rise in REITs, Wells Fargo’s position remains unchanged. The real estate industry’s skepticism is rooted in several important considerations.
First, historical data suggests that falling interest rates do not always guarantee strong performance for REITs. Despite a favorable interest rate environment between 2020 and 2022, the relative performance of REITs remained disappointing. This historical trend casts doubt on the sustainability of recent gains.
“Second, REITs have shown poor relative strength for years, and we are not convinced this long-term trend has changed,” the analysts said. The long-term trend of underperformance raises questions about whether recent improvements represent a significant turnaround or just a temporary anomaly.
Third, analysts predict a slowing US economy that will continue until early 2025. “If this happens, we suspect that more economically sensitive sectors such as real estate could suffer. Furthermore, the chart below shows that real estate loan delinquencies have increased in recent years to levels last seen in 2013,” the analysts said.
While Wells Fargo is generally cautious about real estate, it identifies several subsectors as less cyclical and benefiting from specific trends.
Data center REITs are booming thanks to the growing demand for data storage and processing. Industrial REITs are benefiting from changes in e-commerce and supply chains. Self-storage REITs are resilient under different economic conditions.
Telecommunications REITs are expanding with growing network infrastructure and connectivity. These subsectors appear more promising within the real estate sector in general.
Wells Fargo recently adjusted its outlook for several sectors. In an Aug. 6 note, the brokerage upgraded U.S. small-cap stocks, indicating the worst of the operational challenges may be over.
Communication Services was upgraded due to strong secular growth trends in areas such as search, social media and AI. Healthcare costs were cut as Wells Fargo expects a shift toward faster economic growth.
Wells Fargo has seen a rise in credit spreads within the Bloomberg US High Yield Corporate Bond Index amid recent market volatility. This increase in credit spreads creates an attractive entry point for high-yield, taxable fixed income securities.
The broker’s updated guidance reflects a more neutral stance on high-yield bonds, recognizing improved fundamentals such as better interest coverage and declining default rates.
Mergers and acquisitions (M&A) activity, while below the long-term average, has increased slightly. This comes amid optimism about a possible economic slowdown and future interest rate cuts.
Current deal terms are consistent with historical trends, but high interest rates and economic uncertainty continue to limit deal activity.
