Despite an overall positive performance in 2024, the real estate sector has significantly lagged the broader market in the fourth quarter, as rising interest rates took a toll on key metrics. The Morningstar US Real Estate Index saw a modest 5% increase over the past year, far behind the 24% gain in the broader US equities market. The sector’s performance in Q4 was particularly weak, falling 8%, while the broader market posted a 3% gain.
The underperformance of the real estate sector can be primarily attributed to fluctuating interest rates throughout 2024. The sector has shown a negative correlation with interest rate movements, which became evident when rates began to climb again in October and November, dragging down the sector’s performance after a promising start to the year. Despite a dip in the fourth quarter, the real estate sector remains slightly undervalued relative to fair value estimates. Currently, the median stock in the sector is trading at an 8% discount to Morningstar’s fair value assessment, with 5% of companies in the 5-star range and 28% in the 4-star range.
The deceleration in net operating income (NOI) growth from the highs of 2022 has become apparent across most real estate subsectors, though some areas are maintaining growth in line with long-term averages. For instance, healthcare and industrial sectors continue to show strong NOI growth, while others, such as office and retail, are experiencing slower expansion. Many companies have reported earnings in line with expectations and have largely maintained their 2024 forecasts.
One of the notable trends is the shift in performance drivers from interest rates to sector-specific factors. While healthcare and industrial REITs (Real Estate Investment Trusts) have benefitted from stable income streams, sectors like office and retail are grappling with post-pandemic challenges. Despite these challenges, several REITs, including Kilroy Realty and Healthpeak Properties, continue to offer attractive opportunities for investors.
Top Picks in the Real Estate Sector
Kilroy Realty (KRC)
Fair Value Estimate: $59.00
Rating: ★★★★
Kilroy Realty has struggled since the onset of the COVID-19 pandemic, with its stock declining despite a notable increase in net operating income (NOI) driven by new development projects and acquisitions. The company holds a high-quality portfolio, with buildings averaging just 11 years old, far younger than the 34-year average for other office REITs. Despite the uncertainty surrounding the future of office spaces, Kilroy is poised to benefit from the ongoing trend toward high-quality office real estate. With a strong balance sheet and low leverage, Kilroy’s undervaluation presents an appealing opportunity for long-term investors.
Healthpeak Properties (DOC)
Fair Value Estimate: $30.50
Rating: ★★★★★
Healthpeak Properties has faced a selloff due to rising interest rates, but its focus on medical office and life science properties should provide a stable, recession-resistant income stream. The company’s development pipeline promises yields above its cost of capital, ensuring continued cash flow growth. The market’s current cap rate, however, undervalues Healthpeak’s portfolio of stable assets, presenting a buying opportunity for investors seeking stability in the healthcare real estate sector.
Sun Communities (SUI)
Fair Value Estimate: $172.00
Rating: ★★★★
Sun Communities owns a portfolio of manufactured housing communities, RV parks, and marinas in sought-after vacation destinations. The company has experienced strong same-store NOI growth in recent years, with many segments nearing their historical peaks. Sun has also made progress in converting transient customers into long-term annual memberships, which should provide more stable and higher growth revenue. As interest rates stabilize, the market is likely to recognize Sun’s strong internal growth, making it a promising investment.
Overall, while the real estate sector faces challenges from rising interest rates and a deceleration in growth, these select companies remain well-positioned for continued success in the long term.
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