REIT performance is on the rise, but Wells Fargo says to remain cautious on Real Estate By Investing.com

Real Estate Investment Trusts (REITs) have seen a strong comeback in recent months. From July 1 to August 16, 2024, the S&P 500 real estate index rose 9.9%, outpacing the 1.4% gain.

Market expectations of a change in Federal Reserve (Fed) interest rate policy largely drove this increase. REITs are typically affected by changes in interest rates due to their reliance on external financing.

Despite this positive performance, Wells Fargo analysts remain cautious about the real estate sector and have a negative view of REITs.

Wells Fargo’s cautious stance toward REITs and the broader real estate sector has been in place for several years.

Since March 2022, analysts have consistently ranked the S&P 500 Real Estate sector as an underperformer relative to other S&P 500 sectors. Even with the recent rise in REITs, Wells Fargo’s position remains unchanged. The brokerage’s skepticism is rooted in a few 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 calls into question the sustainability of recent gains.

“Second, REITs have shown weak 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 the recent improvements mark a significant change or just a temporary anomaly.

Third, analysts forecast a slowdown in the US economy that will extend into early 2025. “If this happens, we suspect that more economically sensitive areas such as real estate could have suffered Additionally, the chart below shows that in recent years, mortgage delinquencies have increased to levels last seen in 2013,” the analysts said.

Wells Fargo, while generally cautious about real estate, identifies several subsectors as less cyclical and benefiting from specific trends.

Data center REITs are thriving due to the growing demand for data storage and processing. Industrial REITs capitalize on changes in e-commerce and supply chain. Self-storage REITs are resilient in various economic conditions.

Telecom REITs are expanding with growth in network infrastructure and connectivity. These sub-sectors look more promising in the real estate sector in general.

Wells Fargo recently adjusted its outlook across several sectors. In a note dated August 6, the brokerage upgraded US Small Cap Equities, indicating that the worst operational challenges may have been passed.

Communication services have been modernized due to strong secular growth trends in areas such as search, social media and AI. Healthcare was downgraded as Wells Fargo expects a shift to faster economic growth.

Wells Fargo has seen credit spreads widen across the Bloomberg US High Yield Corporate Bond Index amid recent market volatility. This increase in credit spreads creates an attractive entry point for high-yielding taxable fixed income.

The brokerage’s updated guidance reflects a more neutral stance on high-yield bonds, acknowledging improved fundamentals such as better interest coverage and a declining default rate.

Mergers and acquisitions (M&A) activity, although below long-term averages, increased slightly. This is due to optimism about a potential economic slowdown and future interest rate cuts.

Current deal conditions are in line with historical trends, but high interest rates and economic uncertainty still limit deal activity.