Real Estate: Sector Underperformed in Third Quarter as Interest Rates Rose

The Morningstar US Real Estate Index rose 6.3% over the trailing 12 months, below the broader US equity market’s 15.3% gain. Most of the underperformance occurred in the third quarter, as real estate fell 5.7% while the broader US equities market rose 3.8%. Over the past few years, the real estate sector’s performance has largely been driven by interest rate movements, as it is negatively correlated with interest rate changes. Rates on the 10-year US Treasury have risen 80 basis points in the last 12 months, with a 50-basis point rise in just the third quarter of 2026, leading to the sector’s underperformance.

Despite the sector’s negative performance, fundamentals were strong. For the second straight quarter, every real estate industry produced positive same-store net operating income growth, with the overall sector averaging 4.4% growth. Most REITs either maintained or raised 2026 guidance after second-quarter results, so we believe the sector’s underperformance does not reflect the overall positive momentum of real estate fundamentals.

The real estate sector is currently trading below our fair value estimates. Our real estate coverage currently trades at a 17% discount to our fair value estimate, which is better than the North American average of about a 5% discount. Currently, 12% of the sector trades in the 5-star range, and another 47% trades in the 4-star range. Meanwhile, 38% of the sector is fairly valued, trading in the 3-star range, while just 3% is trading in the 2-star range.

Long-term interest rates have risen about 80 basis points since the start of the year, causing the Real Estate Index to underperform. However, since the end of February, the sector’s relative performance has moved inversely to rising interest rates, though strong second-quarter earnings temporarily led REITs to outperform. Every REIT sector has reported positive same-store net operating income growth in the first half of 2026, with REITs rising 4.4% on average in the second quarter.

Top Real Estate Sector Picks

Kilroy Realty KRC

• Fair Value Estimate: $50.00
• Morningstar Rating: ★★★★
• Morningstar Economic Moat Rating: None
• Morningstar Uncertainty Rating: High

Kilroy shares have corrected around 60% since the onset of the pandemic, even as the company’s net operating income has increased 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 other office REIT peers. The company should be a prime beneficiary of the flight to quality trend in offices. Further, the company has a strong balance sheet, with the lowest leverage within our office REIT coverage.

Invitation Homes INVH

• Fair Value Estimate: $41.00
• Morningstar Rating: ★★★★
• Morningstar Economic Moat Rating: None
• Morningstar Uncertainty Rating: Medium

Invitation Homes has been down since the third quarter of 2024, as occupancy has declined as pandemic-driven excess demand has slowly worn off and operating expense growth has outpaced revenue growth. However, occupancy should settle at its historical average and operating expenses should decelerate toward revenue growth, both of which should allow same-store NOI growth to pick up in the coming years. We like the company’s mix of starter homes tightly grouped together, which should allow it to run the portfolio efficiently and keep margins high.

Healthpeak Properties DOC

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

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