Recent months have seen a strong rebound in Real Estate Investment Trusts (REITs). From July 1 to August 16, 2024, the S&P 500 Real Estate Index rose by 9.9%, outperforming the S&P 500 Index's 1.4% gain.
Market expectations of a change in Federal Reserve (Fed) interest-rate policy have largely driven this rally. REITs are typically impacted by changes in interest rates due to their reliance on external funding.
Despite this positive performance, Wells Fargo analysts remain cautious about the Real Estate sector and hold a negative view on REITs.
Wells Fargo's cautious stance on REITs and the broader Real Estate sector has been in place for several years.
Since March 2022, the analysts have consistently ranked the S&P 500 Real Estate sector as unfavorable compared to other S&P 500 sectors. Even with the recent uptick in REITs, Wells Fargo's position remains unchanged. The brokerage’s skepticism is rooted in several key considerations.
First, historical data suggests that falling interest rates do not always guarantee strong performance for REITs. Despite a favorable interest-rate environment from 2020 to 2022, the relative performance of REITs remained underwhelming. This historical trend casts doubt on the sustainability of the recent gains.
“Second, REITs have shown poor relative strength for years, and we are not convinced that this long-term trend has changed,” the analysts said. The long-term trend of underperformance raises questions about whether recent improvements mark a significant turnaround or if they are merely a temporary anomaly.
Third, the analysts forecast a decelerating U.S. economy extending into early 2025. “If this does occur, we suspect that the more economically sensitive areas like real estate could suffer. Further, the chart below shows that in recent years, past-due real estate loans have risen to levels last seen in 2013,” the analysts said.
Wells Fargo, while generally cautious about real estate, identifies several sub-sectors as less cyclical and benefiting from specific trends.
Data center REITs are thriving due to growing demand for data storage and processing. Industrial REITs are capitalizing on e-commerce and supply chain changes. Self-storage REITs are resilient in various economic conditions.
Telecommunications REITs are expanding with growing network infrastructure and connectivity. These sub-sectors appear more promising within real estate overall.
Wells Fargo recently adjusted its outlook on several sectors. In a note dated August 6,, the brokerage upgraded U.S. Small Cap Equities, indicating that the worst operating challenges may have passed.
Communication Services was upgraded due to strong secular growth trends in areas like search, social media, and AI. Health Care was downgraded as Wells Fargo expects a shift toward faster economic growth.
Wells Fargo has observed an increase in credit spreads within the Bloomberg U.S. High Yield Corporate Bond Index amid recent market volatility. This rise in credit spreads creates an attractive entry point for high-yield taxable fixed income.
The brokerage’s updated guidance reflects a more neutral stance on high-yield bonds, acknowledging improved fundamentals like better interest coverage and a declining default rate.
Mergers and acquisitions (M&A) activity, while below long-term averages, has increased slightly. This is due to optimism about a potential economic slowdown and future interest rate cuts.
Current deal terms align with historical trends, but high interest rates and economic uncertainty still limit deal activity.