Rates and REITs: Can the real estate rally hold?

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Will we remember the 18th day of September? Those betting on a September U.S. Federal Reserve rate cut had reason to cheer last Wednesday. Although the Fed remained on pause for its eighth consecutive meeting, its policy statement acknowledged both aspects of the central bank’s dual mandate: price stability and maximum employment. The change in language signaled that the primacy of inflation-fighting over the past two years may finally start giving way to a greater emphasis on fostering economic growth. Fed Chair Jerome Powell said as much during his post-announcement press conference, noting a rate cut was possible “as soon as September.” Powell also reaffirmed that the rate decision still depends on “the totality of the data, the evolving outlook and balance of risks.”

The risk that data dependence may go — or has already gone — too far. A sharp selloff in U.S. equity markets the two days after the Fed’s rate announcement may reflect investor worry that the Fed has fallen behind the curve. At the same time, last week brought another batch of data releases making a case for a September cut (and possibly more by year-end):

• The JOLTS (Job Openings and Labor Turnover Survey) report for June showed the number of available positions declined to 8.18 million, or 1.2 openings per seeker (a three-year low).
• Reflecting softer demand for labor, the Employment Cost Index (ECI), a measure of inflation in wages and employer-paid benefits, slowed to +0.9% in the second quarter (Figure 1), down from +1.2% in Q1 and well below its most recent peak of +1.4% in the first quarter of 2022.
• Friday’s nonfarm payrolls report for July confirmed the employment slowdown, with a tepid 114,000 new jobs created for the month — lower than the consensus estimates of 175,000 and last month’s downwardly revised 179,000. The unemployment rate moved higher to 4.3%, while wage inflation (+3.6% year-over-year) fell compared to June. All told, the weaker jobs data helped increase the market odds for multiple Fed rate cuts this year.

Investors seeking to take advantage of what increasingly looks like a lower-rate environment on the horizon have a number of options to consider, including a portfolio allocation to listed public real estate assets.

Portfolio considerations

Publicly listed U.S. real estate has endured a tough five-year stretch, absorbing the impact of the pandemic and then a Fed rate-hiking cycle that was unprecedented in its scope and speed. But with an improved outlook for inflation and expectations for the Fed to start cutting rates this fall, real estate was the best-performing sector in the S&P 500 Index for July, returning +7.2%. We believe the recent rally has room to run, as U.S. real estate investment trusts (REITs) are still trading at a 6% discount to their net asset value, as measured by the MSCI US REIT Index (Figure 2).

We expect real estate to enter a new a fundamental cycle over the next year or two, due to very little new supply having been built in the office, retail and senior housing property sectors since the pandemic. Even in an area like apartments, which has seen outsized supply over the past several years, we anticipate new inventory will fall off sharply in 2025, which bodes well for rent growth. Among the factors inhibiting expanded supply (and thus supporting higher rents) is a steep rise in construction costs, which have jumped 44% since 2020.

Senior housing remains one of our favorite areas in the commercial real estate universe. These properties continue to claw back occupancy in their recovery from the pandemic, with operators now having recouped more than 85% of their Covid-era decline. Senior housing operators also benefit from high operating leverage, which means occupancy gains should ultimately result in robust net operating income growth over the next few years. Additionally, the aging population will continue to feed strong demand, while an overall lack of affordable housing should support the sector as well. We also believe rent growth will remain well above historical levels.