Real Estate: Sector Underperformed in Q4 Due to Rising Interest Rates

The Morningstar US Real Estate Index was up just 5% over the trailing 12 months, well below the 24% gain seen by the broader US equity market. However, the real estate sector significantly underperformed the broader market in the fourth quarter of 2024, falling 8% compared with a 3% gain by the broader US equities market.

After a Strong Third Quarter, Real Estate Performance Nearly in Line With US

The real estate sector is currently trading slightly below our fair value estimates. The median stock in our real estate coverage currently trades at an 8% discount to our estimate of fair value, which is slightly better than the North American average. Currently, 5% of the real estate sector is trading in the 5-star range, 28% is trading in the 4-star range, 49% is trading in the 3-star range, 18% is trading in the 2-star range while none of the real estate companies in our coverage universe are trading in the 1-star range.

Real Estate Sector Currently Trading at Slight Discount to Fair Value

The sector’s performance has been driven by interest-rate movements throughout the year, with its performance negatively correlated with changes in interest rates. While rates fell in July and August, rising rates in October and November led to the sector’s fourth-quarter underperformance. Same-store net operating income growth continues to decelerate across most real estate subsectors from the historic highs seen in 2022, though several are producing growth around their long-term historical averages. Most companies reported results in line with our expectations and did not significantly change their 2024 guidance.

The US Real Estate Index had previously performed in line with interest-rate movements from July 2023 through September 2024. While the sector underperformed broader equities in the fourth quarter, the relationship between its absolute performance and interest rates decoupled. While healthcare and industrials continued producing strong net operating income growth, other sectors decelerated, producing growth at or below the historical average of 2.5%.

UST Rate Movements Have Been the Driving Factor Behind REIT Performance

Several REIT Sectors Produced Solid Same-Store NOI Growth in Q3

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 fallen since the onset of the covid-19 pandemic, even as the company’s net operating income has increased materially due to the completion of development properties and acquisitions. We recognize the uncertainty surrounding the future of office real estate, and we believe the environment will remain challenging in the near to medium term. We also believe the selloff has been overdone, and that 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 other office REITs. The company should be a prime beneficiary of the flight-to-quality trend. Further, it has a strong balance sheet with the lowest leverage within our office REIT coverage.

Healthpeak Properties

• Fair Value Estimate: $30.50
• Morningstar Rating: ★★★★★
• Morningstar Economic Moat Rating: None
• Morningstar Uncertainty Rating: Medium

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

Sun Communities

• Fair Value Estimate: $172.00
• Morningstar Rating: ★★★★
• Morningstar Economic Moat Rating: None
• Morningstar Uncertainty Rating: Medium

Sun SUI owns a portfolio of manufactured housing communities, recreational vehicle communities, and marinas in desirable locations for second homes or vacation properties. Most of Sun’s segments have produced strong same-store NOI growth over the past five years, with many nearing their historical highs. Management continues to make progress in converting transient business into annual memberships, which produces more stable revenue and tends to have higher growth over the long term. We believe Sun will produce same-store NOI above the residential REIT average over the next several years, and that the market will recognize its strong internal growth story when interest rates stabilize.