Why Consider Real Estate Sector When Interest Rates Fall

With the Federal Reserve signaling that it intends to cut interest rates when inflation has cooled sufficiently, investors have been on the hunt for investments that perform well in that climate.

In this article I would like to look at how S&P 500 performance returns have been like when rates fall over the past year.

One of the way we can look at is the level of rates compared with inflation. The higher the starting point of short-term interest rates versus inflation, the bigger the market return has been the following year.

This metric offers a way of capturing the potential firepower of Fed policy, if the Fed needed to cut rates further, can it do so and at what rate?

I believe we have seen the current starting point from CME Fedwatch tool with the Fed funds target rate of 5.25%–5.50% but inflation lower than 3%, this has historically been a positive mix for the stock market.

From the chart, the stock market has often seen double-digit returns when the Fed is cutting interest rates, but it depends on what is motivating the Fed's moves.

When the Fed cuts its benchmark interest rate, it is usually for one of two reasons:

Because economic growth is faltering, and lower rates may help support it. This is what happened during the financial crisis in 2008 and the pandemic in 2020.

Because higher rates have done their job of bringing down inflation, so the Fed can recalibrate its policy.

So as investors how can we invest in order to capture the opportunity presented by falling interest rates. I would look at the real estate sector.

Sectors that are sensitive to interest rates, such as Real Estate, usually lead in the run-up to a first rate cut. Both sectors have also shown low valuations, which may provide a margin of safety and indicate that the sectors are pricing in too much bad news.

Property investments are financed. Lower interest rates mean lower debt payments for property buyers. And lower debt payments improve the economics of property deals. As a result, real estate companies can increase their investing activity and grow their portfolios. That gives them more inventory to lease out to customers. The end result should be sales and profit growth.

If we looked at the performance of the real estate sector over the past 4 year, we could see that they have suffered when rate hike is intensive and current year-to-date, it has not recovered.

On the other hand, we are seeing XLRE moving from improving to leading quadrant and have stayed in the leading quadrant for the past few weeks, this showed that Real Estate sector are reacting to the possibility of a rate cut in September more positively.

Hence, I would be planning to take some positions on the XLRE fund.

From what we have seen in the past, S&P 500 performance returns when interest rates start to fall and from what we understand, interest rates would benefit real estate as their investments are financed, this would mean lower repayment for property owners, hence this should help to push the sector to perform much better.

Falling interest rates push up the prices of real estate, all else equal. REITs also pay hefty dividends, so lower rates make those dividends more attractive, too. Plus, REITs also benefit because lower rates make it cheaper for them to borrow money, which they must do to operate.

Appreciate if you could share your thoughts in the comment section whether you think real estate sector would benefit from the falling interest rates?

Disclaimer: The analysis and result presented does not recommend or suggest any investing in the said stock. This is purely for Analysis.