While many homeowners have experienced fantastic returns on their residential properties the past few years, with average national home prices appreciating 29% since the beginning of the COVID-19 pandemic in 2020, some areas of commercial real estate have not been so fortunate.
Higher borrowing costs due to increased interest rates, the shift to remote work, and worries about the ability of smaller regional banks holding commercial real estate loans to absorb potential losses have hurt prices. In some office-heavy markets like San Francisco, commercial real estate prices have fallen 40% since March 2022.
Most individual investors aren’t investing directly in commercial real estate, however. Instead, the most accessible and cost-effective way to participate in this market is through publicly traded real estate companies called real estate investment trusts, or REITs for short. As with the broader commercial market, REIT performance has been volatile, with the Real Estate GICS Sector for the S&P 500 index declining 8.3% in 2024.
A Quick Primer on REITs
The next time you visit a big shopping mall, office building, or hotel, chances are high it’s owned by a REIT. Publicly traded REITs trade on stock exchanges like the New York Stock Exchange (NYSE) or NASDAQ, and investors can buy and sell shares for little or no cost, just like they would a mutual fund or exchange-traded fund.
The REIT’s portfolio managers purchase and manage various real estate properties on behalf of investors. They are required to pass through at least 90% of their taxable income to shareholders in the form of dividends each year. For this reason, we consider REITs to be a “hybrid” between a stock and a bond. They are stocklike in that REITs can enjoy long-term appreciation (about 10% annually on average over the last 40 years) and bondlike due to the income stream they provide.
Most importantly, REITs have historically had a low correlation with stocks, meaning their performance often “zigs” when stocks’ performance “zags,” adding additional diversification to investment portfolios.
Volatility Isn’t New
Anyone who has watched or participated in real estate investing over the last 20 years is no stranger to how volatile it can be, as illustrated in the stock market sector performance “quilt chart” below. Real estate, represented by the brown rectangle, fell over 42% during the 2007/2008 financial crisis. But, investors who could withstand the pain were soon rewarded, as returns rebounded by 27% and 32% in 2009 and 2010, respectively.
The Federal Reserve’s swift interest rate increases in 2022 brought similar pain, leading real estate shares to tumble over 26%. Returns in 2023 of 12% partially offset these losses, and it remains to be seen if the drawdown so far in 2024 will continue.
Finding Stability Amidst Uncertainty
Amidst the challenges, there are reasons for optimism. While certain segments of the commercial real estate market, such as retail and office space, have faced significant headwinds due to the rise of e-commerce and work-from-home preferences, not all sectors are in decline. Many people are unaware that REITs invest in other types of real estate, including data centers, cell phone towers, and self-storage facilities, all of which have experienced price increases and a rise in demand as the economy shifts.
While small banks with significant exposure to commercial real estate loans may face challenges, broader systemic risks appear manageable. The market has shown past resilience, with flexibility in loan modifications and staggered maturity schedules providing avenues for owners and lenders to navigate downturns successfully.
Office attendance has stabilized at around 50% of pre-pandemic levels, signaling a gradual return to in-person work environments. Leasing activity has shown improvement in several regions, offering hope for a rebound in occupancy rates.
Embracing Opportunity
While real estate investing may be marked by uncertainty and volatility, it’s essential to maintain sight of the underlying resilience of the market. As with any long-term investment, trying to time the ideal moment to enter or exit the real estate market, especially based on recent performance, is a losing proposition. Instead, taking a sensible approach to the amount of real estate in one’s portfolio and seeing it as an important diversifier with a strong historic (but volatile) track record is the way to success.
Do you have questions about your real estate holdings or feel ready to add some exposure to your portfolio? Contact us and schedule an introductory call. We’re here to help.
Uplevel Wealth is a fee-only, fiduciary wealth management firm serving clients in Portland, OR, and virtually throughout the U.S.
