Office Rebound Expected in 2025 While Other Real Estate Stocks to See Trouble

By Investor Empires On Dec 20, 2024

(Bloomberg) — It’s been a tough couple of years for real estate stocks since the Federal Reserve began raising interest rates in 2022, with borrowing costs rising and the real estate market collapsing. Despite a healthy recovery in mid-2024, the outlook for 2025 is not particularly encouraging.

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But that doesn’t mean investors should expect a sea of red in real estate stocks next year. Instead, it’s likely a stock-picking market, where some rise, others fall, and the group doesn’t move in perfect unison, according to Adam White, senior equity analyst at Truist Advisory Services.

That’s not great news for the residential market, which is expected to face challenges from stubbornly high mortgage rates and limited supply in 2025, especially after Federal Reserve Chair Jerome Powell’s comments on Wednesday suggesting fewer interest rate cuts. The average interest rate on a 30-year fixed mortgage rose this week for the first time in a month, Freddie Mac said in a statement Thursday.

But there is growing optimism in one of the most beaten-up corners of the market: office REITs.

“Where REITs can really compete is in their cost and availability of capital, and that may be the case for offices,” said Uma Moriarity, chief investment strategist at CenterSquare Investment Management. “When you think of a premium asset in any given market, it’s likely to be owned by a REIT.”

The group has taken a hit since the start of 2022, with the S&P Composite 1500 Office REITs index falling more than 30% while the S&P 500 index is up 24%.

This difference is not entirely shocking given the headwinds facing the real estate industry along this stretch. The cost of borrowing rose as the Federal Reserve raised interest rates 11 times between March 2022 and July 2023, the regional banking crisis of March 2023 crippled local lenders, and employers struggled to force workers to return to their offices after coronavirus lockdowns.

Office recovery

These pressures have led to a decline in real estate stocks across the board. U.S. REITs have been cheap or less expensive than the S&P 500 11% of the time over the past 20 years, according to Todd Kellenberger, a REIT client portfolio manager at the major asset manager. Office REITs are still down about 60% from pre-Covid levels compared to the rest of the REIT market, making them a decent target for growth, according to Moriarity.

In many ways, the workplace real estate recovery has already begun. Office REITs posted a total return, including dividends and stock price increases, of more than 28% in 2024, according to data from the Nareit trade association, making them among the best performers in the group after data center and specialty REITs. This is a significant shift from 2023, when office REITs posted a 2% total return, and 2022, when they fell 38%, Nareit figures show.

The focus on prestige office properties that Moriarity referred to is happening now as well, as seen in the difference between high-quality and low-quality names.

Companies like SL Green Realty Corp., which focuses exclusively on office buildings in Manhattan, as well as Vornado Realty Trust and Highwoods Properties Inc., which operate in upscale markets across the U.S., have seen year-to-date gains of 30% to more than 50%. . Meanwhile, companies like Office Properties Income Trust, whose largest tenant is the federal government, are down about 85% in 2024.

“For portfolios with the strongest assets, I wouldn’t be surprised to see another strong year,” Moriarity said.

Trouble in paradise

The outlook is not nearly as optimistic for residential real estate. Home builders were the unique beneficiaries of higher mortgage rates as builders took advantage of a tight resale market and growing demand. But after a massive 74% surge since the Fed started raising interest rates, the sector is starting to slow.

The US central bank’s intention to slow down interest rate cuts is likely to keep mortgage interest rates higher than expected. This extends to dwindling supply as more homeowners are reluctant to move when they are tied up with an existing mortgage at a much lower rate than they can get now.

Homebuilder stocks are on pace to end the year with a loss of 1.6%, compared to their 80% jump in 2023. The SPDR S&P Homebuilders ETF is currently seeing its biggest quarterly outflow in two years. The S&P Composite 1500 Home Construction Index has fallen 25% since October 18, putting it in bear market territory.

Even luxury homes, the part of the residential real estate market that seemed impervious to outside forces as deep-pocketed buyers avoided high borrowing costs using cash, could hit a wall, according to Cole Smead, CEO and portfolio manager. At Smid Capital Management in Phoenix.

“The thing I consider more negative is luxury real estate,” he said. “It would be terrible.”

Smid expects the shares to mirror the performance of the broader stock market, which he expects bearish for 2025. Luxury homebuilder Toll Brothers Inc., until recently the best-performing homebuilding stock this year, has lost 27% since Nov. 25 and just forecast. Gross margins are weaker than expected, underscoring industry concerns about pricing pressures.

The all-cash deals that kept the market buoyant are at risk of higher borrowing costs as well. Many of these deals are not made using physical cash, but rather through secured lines of credit that are “similar to cash,” Smid said.

“That’s what was fueling the luxury home market,” he said. “So what if those assets are suffering? What will that owner do? Will they sell securities or will they sell the second or third home? They will sell one of the two, and that will hurt both parties.”

As investors consider how to play the real estate market heading into 2025, Truist’s White warns against simply buying a sector fund. Instead, he urges a stock picker’s approach. Data center REITs, real estate services companies and senior living REITs are areas where he sees opportunities.

“You’ll want to be more selective,” White said. “It will be difficult to achieve the same returns in 2025.”

(Adds details about rising mortgage rates in third paragraph)