Stocks have seen immense volatility so far in 2018, with major market benchmarks having seen huge initial gains, fallen back in the first official market correction in years, and then climbing back toward gains for the year. Yet in the carnage that the market's roller-coaster movements left behind, one particular sector -- real estate -- hasn't shown signs of bouncing back.
Investing in real estate directly requires specific knowledge about a particular location, so most investors choose real estate investment trusts or other companies that pool together exposure to a large number of different properties for diversification purposes. As you can see below, major ETFs that focus on REITs and other real estate investments have accumulated billions of dollars in assets. Yet their performance so far this year raises questions about whether they're a good idea for investors more broadly.
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Is real estate heading lower?
One reason why investors might be confused about the performance for real estate and REIT-oriented ETFs is that there hasn't been much talk about any weakness in the real estate market overall. When you look at residential housing prices, they remain quite strong, especially in several hot markets that in some cases have regained all of their losses from the housing bust of the mid- to late-2000s and are now at all-time highs.
But the thing to understand about REITs and real estate stocks is that their price movements are a lot more continuous than what most people are familiar with seeing. There's no daily market for homes, so you can't see on a daily basis whether the value of your home has gone up $1,000 or down $1,000. For most people, the only time you get a true sense of the value of your home is when you buy it and when you sell it, and the change in price flattens out your sense of any volatility that might have been in the market during the period you owned your home.
Rates on the rise
The most important indicator of immediate value for REITs and real estate stocks is what the cash flows they generate are worth. That's determined by comparing their yields to what comparable fixed-income investments will generate in income. Although successful real estate investments typically don't have income that's truly fixed -- most rent clauses have escalators that allow payments to grow over time -- they're nevertheless sensitive to rate changes for Treasury bonds and similar investments.
Investors have already seen a dramatic rise in prevailing interest rates. The yield on the 10-year Treasury bond has jumped almost half a percentage point in less than two months to 2.9%, and some bond market participants fear even bigger hikes ahead. With an already solid economy that will now see the impact of large tax reductions at the corporate level, concerns about nascent inflation are on the rise.
Keep an eye on real estate
Throughout the past nine years of economic expansion, real estate has played a pivotal role. The residential real estate market has largely recovered from the housing bust in most key locations, and commercial real estate investments have done extremely well. Falling interest rates during those years were important contributors to that performance, and now that rates are starting to head higher, it's important for investors in the space to understand the potential for short-term losses like the ones we've seen so far in 2018 for real estate ETFs.
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