Real Estate: Sector Underperformed in Q2 Due to a Rise in Teasury Interest Rates

The Morningstar US Real Estate Index was up 11.9% over the trailing 12 months, slightly worse than the 15.1% gain seen by the broader US equity market over the same period. Similarly, the sector underperformed in the second quarter, gaining just 7.02%, compared with a 22.8% gain by the wider market.

Real Estate Underperforms in Second Quarter, While 12-Month Performance Is in Line

Our real estate coverage currently trades at a 15% discount to our estimate of fair value, which is better than the North American average of an approximately 4% discount. Currently, 18% of the sector is trading in the 5-star range, 49% is trading in the 4-star range, 23% is in the 3-star range, 10% is in the 2-star range, and no stocks are in the 1-star range.

Two-Thirds of Real Estate Sector Trading at Material Discount to Fair Value

The sector’s performance is negatively correlated with changes in interest rates. Rates have remained roughly flat over the past year, resulting in a relative performance in line with the broader market. However, rates on 10-year US Treasuries have increased by approximately 25 basis points over the past three months, driving real estate’s underperformance. Same-store net operating income growth has flattened out, with an average year-over-year growth rate of around 2%, as expense growth remains slightly ahead of revenue growth in many sectors. Most companies reported results that were generally in line with our expectations on first-quarter earnings calls, and our estimates for 2025 remain typically within management’s guidance for the year.

US Treasury Rate Movements Have Been the Driving Factor Behind REIT Performance

Additionally, many REITs are reporting same-store net operating income growth below the historical average of 3%, although NOI is expected to increase slightly as expense growth decelerates.

Same-Store NOI Grew Just 2.1% Due to Elevated Expense Growth

Top Real Estate Sector Picks

Kilroy Realty

• Fair Value Estimate: $59.00
• Morningstar Rating: ★★★★★
• Morningstar Economic Moat Rating: None
• Morningstar Uncertainty Rating: High

Kilroy KRC shares have corrected by more than 50% since the onset of the pandemic, despite the company’s NOI increasing materially. We believe the selloff has been overdone and the market is not recognizing the value of the company’s non-office-related assets and land bank. Kilroy has a high-quality portfolio with an average building age of 11 years, compared with 34 years for its office REIT peers. The company should be a primary beneficiary of the flight-to-quality trend in the office sector. Further, it has a strong balance sheet with the lowest leverage within our office REIT coverage.

Federal Realty Investment Trust

• Fair Value Estimate: $142.00
• Morningstar Rating: ★★★★★
• Morningstar Economic Moat Rating: None
• Morningstar Uncertainty Rating: Medium

Federal Realty’s FRT high-quality retail centers should produce higher retail sales growth than the brick-and-mortar average, keeping occupancies high and driving high re-leasing spreads. Federal Realty’s portfolio has the highest average population density and per capita income among all shopping center REITs. The company’s strong internal and external growth prospects should also allow Federal to continue supporting a high dividend yield. We believe the company has sold off due to 10% of rent coming from office tenants. Still, Federal’s high-quality portfolio should trade at a multiple premium to the industry and its shopping center peers.

Healthpeak Properties

• Fair Value Estimate: $27.50
• Morningstar Rating: ★★★★★
• Morningstar Economic Moat Rating: None
• Morningstar Uncertainty Rating: Medium

Healthpeak’s DOC management team strategically focused on the medical office and life science portfolios. These sectors should provide steady, recession-resistant revenue growth. Healthpeak’s development pipeline should also produce yields above the company’s cost of capital, even amid higher interest rates, producing additional cash flow growth for shareholders. The company sold off due to rising interest rates, but we believe the current market-implied cap rate undervalues Healthpeak’s portfolio of stable assets.