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Even as stock and bond investors are cheering the end of the Federal Reserve’s interest rate hikes, the real estate market continues to face challenges. One such example of real estate distress is the recent bankruptcy of office-sharing company WeWork, which just four years ago was assigned a $47 billion valuation. Another is the record-low activity in the residential housing market. That said, even with higher rates, the real estate market is highly differentiated and not all areas have performed similarly.
Residential Real Estate Cools
The U.S. housing market, which has seen strong appreciation in recent years, has softened considerably since the Fed began raising rates. Higher mortgage rates, which typically translate into higher monthly payments for would-be buyers, have priced many out of the market. Despite some recent improvements, weekly mortgage-application volume, a leading indicator of the housing market, is hovering near multi-decade lows.
As housing activity has waned, we’re seeing some stress among homeowners, as evidenced by a notable increase in foreclosures. In September, foreclosure filings increased by 11% from the previous month and by 18% for the one-year period, according to ATTOM, a leading curator of land, property and real estate data, in its Q3 2023 U.S. Foreclosure Market Report.
While sharp increases in foreclosures grab attention – as with any type of data – context is important. Even with recent increases, foreclosures remain well below levels seen during the global financial crisis. And, as one might expect, the expiration of the federal moratorium on foreclosures in late 2021 has contributed to the increase in filings.
One of the factors that also differentiates the recent correction from past ones is the low supply of properties for sale. So-called housing inventory was tight even before the Fed began raising the fed funds rate. Higher rates have further suppressed inventory by making many homeowners with low mortgage rates reluctant to move and give up their attractive financing.
The imbalance between supply and demand has helped prop up home values even as rates have climbed. In fact, prices are beginning to rise again, albeit at a much slower pace than they did in recent years.
Mixed Performance for Commercial Real Estate
Among commercial real estate subsectors, the office market has suffered disproportionally — owing to higher rates and weak demand resulting from the so-called long shadow of Covid-19. As many of us know, Americans have yet to return to the office en masse, as many landlords hoped they would. Instead, hybrid-work arrangements have become commonplace in the post-pandemic era.
In the third quarter, the national vacancy rate for office properties topped 19% and was near its historic high of 19.3% (set in 1991). Rent growth has been stagnant, and prices for office buildings have fallen an estimated 20% to 30% from peak levels.
The delinquency rate on commercial mortgage-backed securities tied to the office sector has nearly doubled over the past year, climbing to 5.75% in October. Commercial mortgage-backed securities are fixed-income investment products (sold to high net-worth and institutional investors) that help support the flow of capital to property investors.
Office landlords with a lot of debt are especially vulnerable to the double whammy of higher rates and soft demand. The headline-grabbing bankruptcy of WeWork provides a stark example of this, although some of the company’s difficulties are unique to WeWork.
Despite the troubled office market, some subsectors are doing okay in today’s higher-rate environment.
Data centers, for instance, are benefitting from strong demand tied to the increase in remote work and the growth of cloud computing. Data centers house equipment that stores and processes data. Some companies operate data centers for their own purposes, while others own and operate data centers that are leased to third-party users. Revenue for the subsector is expected to grow at a compound annual rate of 5.45% through 2028.
Hotels are another bright spot. Although the industry suffered mightily during Covid-19 lockdowns, the surge in leisure travel coming out of the pandemic has helped it to stabilize fairly quickly. In many markets, hotel operators have been able to charge more for rooms, which has helped offset the impact of the slow return of business travel. Revenue per available room, a hotel-industry performance metric, has climbed steadily since 2020 and is now near pre-pandemic levels.
Such fundamentals have contributed to positive equity-market returns for hotels and several other real estate subsectors this year. Overall, though, the real estate sector has had negative performance this year. (It’s worth noting that some of the largest publicly traded hotel and data-center companies have international exposure.)
Why Does Real Estate Matter?
Real estate plays an important role in the overall health of the economy. It’s one of the key indicators of economic growth, and home ownership is an important source of wealth creation for Americans. Home equity accounts for more than a quarter of aggregate household wealth, according to the latest Census Bureau data.
In addition, investors with broadly diversified equity portfolios typically have some exposure to real estate. Although it’s one of the smallest S&P 500 sectors, real estate makes up 2.4% of the index, as measured by weighting.
Many in the real estate market are likely breathing a sigh of relief over the prospect that the Fed may be done raising rates. Recent inflation reports suggest that the central bank’s work to tame inflation is largely done. Still, rates may remain elevated for some time, and the full effect of the higher rates can take time to work its way through the economy.
We’ll continue to keep an eye on the critical real estate sector. As always, the key to navigating volatility remains a broadly diversified portfolio.
Invest wisely and live richly,
The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Advisor Services Holdings C, Inc., d/b/a Kestra Holdings, and its subsidiaries, including, but not limited to, Kestra Advisory Services, LLC, Kestra Investment Services, LLC, and Bluespring Wealth Partners, LLC. The material is for informational purposes only. It represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. It is not guaranteed by any entity for accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was created to provide accurate and reliable information on the subjects covered but should not be regarded as a complete analysis of these subjects. It is not intended to provide specific legal, tax or other professional advice. The services of an appropriate professional should be sought regarding your individual situation. Kestra Advisor Services Holdings C, Inc., d/b/a Kestra Holdings, and its subsidiaries, including, but not limited to, Kestra Advisory Services, LLC, Kestra Investment Services, LLC, and Bluespring Wealth Partners, LLC. Does not offer tax or legal advice.