Is real estate a good fit for your investment portfolio?

Investing Insights

The real estate market generated an outsized amount of public interest since the start of the COVID-19 pandemic in early 2020.

As office spaces emptied out and restaurants closed or had to limit business due to health precautions, investors had concerns about the impact on the commercial real estate market. At the same time, the housing market suddenly experienced a dramatic jump in activity.

In this “topsy-turvy” environment, investors who diversify into real estate holdings may be wondering what’s next. As the U.S. economy approaches pre-pandemic conditions, the real estate market bears closer scrutiny. What to expect at this point may vary depending on the part of the market you’re considering investing in.

The housing market – location, location, location

In the early part of 2020, a number of Americans chose to escape large, pricey urban markets. “The combination of shutdowns from COVID-19 and other factors seemed to drive more people away from larger cities and into less populated areas,” says Kevin Weigel, portfolio strategist at U.S. Bank Wealth Management. Home prices soared in certain suburban markets and secondary cities, while some major metropolitan areas saw demand drop.

Across the country, home prices have soared. According to the National Association of Realtors, home prices rose 16 percent in the first quarter of 2021 to a record high, and the median sales price of an existing single family home was $350,000 in May 2021, an almost 24 percent year-over-year increase.1

Persistent low mortgage rates continue to be a driving factor in the number of buyers entering the market. “Given the demand, it appears residential real estate has not yet hit its peak,” says Rob Haworth, senior investment strategy director at U.S. Bank.

Yet by early June, home sales were decelerating, though the reason for the drop off isn’t clear. It could reflect a lack of inventory available to buyers, or perhaps buyers deciding they aren’t willing to keep feeding into a market where prices are straining their wallets.

The environment for investing in real estate can be a mixed bag, depending on the segment you’re considering, but opportunities remain.

What are the prospects for residential real estate from this point? “For those looking to own their primary home, it pays to be active in this market,” says Weigel. “Buyers can still lock into low interest rates and make a solid, long-term investment.” Weigel is less optimistic about residential real estate as an investment in the current environment. “With prices elevated and interest rates likely to head higher in the future, it’s less attractive as a pure investment opportunity right now,” he says.

Another factor that may affect some owners of rental real estate is a proposed change in the tax law. It would alter so-called “like kind” or “1031 exchanges.” Under this long-standing tax law, investors can defer taxes on real estate when profits from the sale of one property are rolled into the purchase of another property. The new law would disallow this type of exchange on gains that exceed $500,000. While the impact may be felt more in the commercial real estate market, it is something homeowners and real estate investors should keep an eye on.

New tax laws affecting capital gains tax rates on high income earners could also have an impact on net after-tax returns for real estate investors as is the case with investments in other types of assets. These changes are only under discussion and have not yet been passed into law.

The commercial real estate market – a mixed bag for REITs

Location and types of property are both key factors in the commercial real estate market. Many investors participate in this market through Real Estate Investment Trusts (REITs).

After facing some headwinds in 2020, the market appears to have undergone an adjustment. REITs generated solid performance in the first half of 2021. Within the S&P 500 index, real estate was the fourth best performing industry year-to-date through May, trailing only cyclical sectors such as energy, financials and materials that all benefited from the solid economic recovery.

“There are clear opportunities developing in the commercial market,” says Haworth. “Most notable are those tied to light industrial properties, particularly given the accelerated rate of growth in e-commerce business since the pandemic began.” These are warehouse-type spaces used as shipping facilities for major online retailers like Amazon. With online business booming, property owners in this segment of the market are in a strong position to attract lease activity.

Another bright spot is communications infrastructure – namely data centers and cell towers –representing one of the largest segments of the REIT marketplace. These have been strong performers as technology played a rapidly expanding role for work and school applications during the pandemic. The increased impact of this segment on the real estate sector is likely to continue. It’s considered a less defensive segment of the commercial REIT market, as business prospects for communications infrastructure firms tend to be directly affected by economic activity. Those trends are often reflected in the broader stock market.

There are segments of the commercial real estate market facing more challenges. One of the most notable is retail space. Several brick-and-mortar retailers did not survive the year of COVID. “Traditional retail was already under duress,” notes Haworth. “The environment created by the pandemic accelerated the shift toward e-commerce. Now we’ll see if that’s a sustained trend.” Yet so far this year, malls and strip mall spaces have, from an investment perspective, performed well, rebounding from a difficult 2020. With the economy returning to a steady state, there are signs of more life in the retail space, but whether that indicates a cyclical upswing that reflects pent-up demand or a trend that can be sustained over a longer period of time is not yet clear.

Office space is another major question mark within the commercial sector. “We’re seeing the urban-suburban divide in this market,” says Weigel. “The big question now that nobody can answer is whether the office environment we came to know prior to the pandemic will return at full strength.” He notes that many companies have adapted a hybrid type of work pattern for employees – with some time spent in the office and some working from home. “Based on the number of long-term tenants that are seeking to sub-lease their office space in certain markets, it indicates that many companies are cutting back on their office space needs,” according to Wiegel. This is particularly true in central business districts. Even with significant office spaces remaining empty due to pandemic-related cautions, leases tend to be for a period of years, so rental income has continued to flow to owners of buildings. It may take a few years for answers about the demand for office space to fully emerge.

Macro-economic factors to watch – inflation and interest rates

Inflation has captured more headlines in recent months, with prices firming up for many goods and services as the economy continues to rebound from the COVID-induced recession. This includes key components of construction, such as lumber and labor. Haworth says if inflation proves to be transitory and not a long-term trend, it may not have a longstanding impact on the real estate market. While median home prices have soared nationwide, Haworth notes that for the pattern to continue, wages for workers will need to rise as well.

Weigel says that inflation tied to an economic boom can allow rental rates and property values to rise. “If income is growing in line with inflation, landlords can boost rents,” he says. “But if incomes and earnings aren’t keeping pace with inflation, it would be more challenging for real estate.”

Interest rates are another critical factor. In the opening months of 2021, the yield on the benchmark 10-year Treasury note rose from 0.93 percent to as high as 1.74 percent in March. Since then, it’s retreated modestly. Mortgage rates generally followed suit. “If interest rates should trend higher, it may be a bigger concern for commercial property activity as higher borrowing costs can become an issue,” says Haworth. “It can impact the housing market too, but more from the standpoint of what’s affordable for buyers rather than the number of buyers in the market.”

The role of real estate in an investment portfolio

Real estate can be an attractive asset class as part of a broadly diversified portfolio. “The returns on real estate investments tend to be less correlated to other types of equities,” says Weigel. That lack of correlation means real estate investment opportunities can generate performance that’s distinct from that of the stock market. This is consistent with the long-standing attraction of real estate as part of a diversified portfolio, and little that has happened in today’s market changes that benefit.

The environment for investing in real estate can be a mixed bag, depending on the segment you’re considering, but opportunities remain. Depending on your objectives, real estate investments offer unique opportunities to generate capital appreciation and income within a broad asset mix. That means real estate remains an applicable investment portfolio diversifier for those still accumulating wealth for future goals as well as for those in retirement.

Talk to your financial professional to review your current portfolio and explore the role real estate is playing or could play to help meet your investment objectives.

Diversification and asset allocation do not guarantee returns or protect against losses.

Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties (such as rental defaults).

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