Recent months have seen a strong rally in real estate investment trusts (REITs). From July 1 to August 16, 2024, the S&P 500 Real Estate Index rose 9.9%, outpacing the 1.4% gain in the Standard & Poor’s.
Market expectations of a change in the Federal Reserve’s interest rate policy were the main driver of the rally. REITs are typically sensitive to changes in interest rates because of their reliance on external funding.
Despite this positive performance, Wells Fargo analysts remain cautious on the real estate sector and have a negative view on REITs.
Wells Fargo’s cautious stance toward REITs and the broader real estate sector has been in place for several years.
Since March 2022, analysts have consistently rated the S&P 500 real estate sector as underweight compared to other sectors in the S&P 500. Even with the recent surge in REITs, Wells Fargo’s position has remained unchanged. The brokerage’s skepticism stems from several key considerations.
First, historical data suggests that low interest rates do not always guarantee strong REIT performance. Despite the favorable interest rate environment from 2020 to 2022, the relative performance of REITs has been disappointing. This historical trend casts doubt on the sustainability of recent gains.
“Second, REITs have shown relative weakness for years, and we are not convinced that this long-term trend has changed,” the analysts said. The long-term trend of underperformance raises questions about whether the recent improvements represent a major shift or just a temporary anomaly.
Third, analysts expect the U.S. economy to slow until early 2025. “If this happens, we suspect that more economically sensitive areas such as real estate could suffer,” the analysts said. “Moreover, the chart below shows that in recent years, delinquent mortgages have risen to levels last seen in 2013.”
While Wells Fargo is generally cautious on real estate, it identifies several subsectors as less cyclical and benefiting from specific trends.
Data center REITs are thriving because of the growing demand for data storage and processing. Industrial REITs are benefiting from changes in e-commerce and the supply chain. Self-storage REITs are resilient in varying economic conditions.
REITs are expanding into the telecom space as network infrastructure and connectivity grow. These sub-sectors look more promising for real estate overall.
Wells Fargo recently revised its outlook for several sectors. In a note dated Aug. 6, the company upgraded its rating on U.S. small-cap stocks, suggesting that the worst of the operating challenges may be behind it.
Communications services were upgraded due to strong secular growth trends in areas such as search, social media and artificial intelligence. Healthcare was downgraded as Wells Fargo expects a shift toward faster economic growth.
Wells Fargo has noted an increase in credit spreads within the Bloomberg U.S. High Yield Corporate Bond Index amid recent market volatility. This rise in credit spreads creates an attractive entry point for high-yield taxable fixed income instruments.
The brokerage firm’s updated guidance reflects a more neutral stance on high-yield bonds, acknowledging improved fundamentals such as better interest coverage and a lower default rate.
Although M&A activity remained below long-term averages, it did increase slightly. This is due to optimism about a possible economic slowdown and future interest rate cuts.
The terms of the current deal are in line with historical trends, but high interest rates and economic uncertainty continue to limit deal activity.