When Standard & Poor’s and MSCI announced in March that real estate would be moving out of S&P’s financial sector to become its own standalone sector in September, performance expectations rose for the sector but fell for financials.
Months before the change took effect under the Global Industry Classification Standard (GICS) system, the S&P Real Estate Select Sector SPDR ETF (XLRE) charged ahead of the S&P Financial Select Sector SPDR (XLF), but then, just as the change was being implemented, that performance reversed in mid-September.
Real estate is now the worst performing S&P 500 stock sector for the past 13 weeks through December 2, down 11.3%, and it’s the second worst performing sector year-to-date after health care, down 4.1%. There are 11 sectors in the S&P 500 and its real estate sector is comprised primarily of Real Estate Investment Trusts (REITs).
Behind the sharp drop in the real estate sector are rising interest rates. Since July 8 the 10-year Treasury yield has surged more than 100 points, from 1.38% to 2.46% on Friday.
As rates rise the borrowing costs rates for REITs increase, which impacts profitability.
Rising rates also make REITs less attractive to investors because as a dividend-yielding investment (by law they have to return at least 90% of their taxable income to investors every year) REITs face increased competition from other income-producing investments paying higher yields.
“Rising interest rates are the number one reason REITs have underperformed since late summer,” said Jeff Kolitch, portfolio manager of Baron Real Estate Fund (BREFX), which invests in many real estate categories, not just REITs.
But rising rates do not necessarily doom all REITs or other real estate investments especially if rates are rising because of a fast-growing economy.
Rental housing REITs, for example, can benefit from faster growth by raising their rents; hotel REITs similarly can raise their room rates
In addition, gaming-related companies with embedded real estate, like MGM, and real estate related companies involved in home improvement such as Sherwin Williams, could do well, says Kolitch. His fund owns both stocks.