XLRE - Real Estate: Our Top Sector Pick For 2024

2023-12-08 16:01:22 ET

Summary

• Real Estate has underperformed throughout the recent rate hiking cycle.
• As inflation appears stalled and rate expectations soften, we think Real Estate could bounce back significantly.
• Additionally, XLRE is the most well-positioned sector from an RRG perspective, a rotational momentum model which has a proven statistical edge.
• We also discuss our favorite stocks within the sector.
• We rate XLRE a "Strong Buy".

Let's face it: Real Estate ( XLRE ) has had a tough year.

Underperforming the indices by more than 16.5% YTD, the sector has been beaten down due to a higher rate environment, concerns around commercial real estate (mostly offices), and reversion from a strong cyclical swing seen in years' past:

However, despite the fact that rates remain high and return-to-office initiatives seem to have stalled , we think that the sector is extremely well positioned to outperform the market in 2023.

This looks especially true when compared with the tech sector, which has led the market this year and now looks unattractively valued .

Today, we'll break down why Real Estate as a sector is set to improve significantly in 2024, along with our top sector picks that you should consider for your portfolio.

Relative Strength

Have you ever heard of something called a "Relative Rotation Graph"? It's a tool that we, along with many other investors, use to get a sense of how stock and sector rotations are expressing themselves in the market.

You can look at rotations on a daily or weekly basis, but we use the 'monthly' setting to see how big-picture rotations are playing out on a larger timescale.

Here's how things look like right now:

As you can see, there are four quadrants; "Improving", "Leading", "Weakening", and "Lagging". Whatever is plotted on this graph tends to move in a clockwise motion around the center point, which allows a level of potential predictability as to where markets will move next.

This doesn't always work, but we did an extensive back test of the last 9 years of data to show how well it works, on average:

In this chart above, we measured where a sector was at the beginning of the month. Then, we measured the performance of the sector in the following month, compared with the performance of the S&P 500.

We found that on average, sectors in the "Improving" quadrant outperformed the S&P the most, while sectors in the "Weakening" quadrant underperformed the market the most.

This doesn't count for trajectory - if we measured that, then the performance difference would be stronger, as some sectors perform badly as they transition from "Leading" to "Weakening", for example - before they officially switch designations. Adjusting for this shows an even stronger edge.

There's also some variation between sectors. For example, the Energy Sector ( XLE ) appears to be very 'cyclical'; - when it leads, it leads for a long time. And, when it lags, it lags the market by a large margin. This tracks with what you may have seen in your own trading and investing.

However, overall, the best time to invest on the long side in a sector is right as it transitions from lagging to improving.

Looking at the chart above, XLRE appears to be the sector with the position and trajectory we like the most. Sure, the sector is 'Lagging' right now, but given the rate situation, we think it could easily move into the "Improving" quadrant in 2024, which would mean serious potential outperformance.

Rates

Real Estate is one of the three sectors that are most impacted by rates - the other two of course being Tech and Utilities ( XLU ). Real Estate and Utilities are generally impacted because they are inherently high-leverage businesses, and Tech is impacted generally on the multiple front, as growth companies tend to command premium valuations that are hit the most as NPV of future cash flows comes down in a hiking cycle.

This explains why XLU and XLRE have had such a rough time since rates began rising in 2022. As rates have risen, these sectors have underperformed as investors model less cash dropping to the bottom line in the future:

However, we recently reached a point of saturation in the rates market.

As the recent CPI reading showed 0% MoM inflation and only 3.2% YoY inflation , it cemented expectations that the Fed was done hiking for now, and inflation could be on the way back down:

This is reflected in the Fed dot plot, which shows that FOMC members anticipate rates will begin decreasing towards ~3% over the coming years, and no members expect that rates will continue on their trajectory higher by 2025:

Markets react to acceleration and deceleration more than they react to surface level readings. As the trends appear to show an 'easier' environment for high leverage businesses like Real Estate in the 2024, when combined with the relative rotation situation, we think it could be the best performing sector of next year.

Stocks We Like

Within Real Estate, there are a few companies that we think are well positioned to capitalize on a potentially solid year as macro winds appear to be at the industry's back.

Those stocks are Realty Income Corporation ( O ), and Alexandria Real Estate Equities ( ARE ):

Both stocks are positioned well on the RRG chart above. This positioning alone should drive returns, as the 'best positioned' stocks within the most well positioned sector.

However, beyond that, both stocks appear to be solid companies fundamentally in their own right.

Realty Income

Let's look at Realty Income Corporation first.

It sports solid revenue and FFO growth, and it's trading at a reasonable valuation, on the lower end of the previous 5-year regression.

Seeking Alpha quant factor grades also rate the stock a "Buy", as you can see below:

We don't love that the company has a history of diluting shareholders consistently, but the company's profitability, growth, and value provide a compelling investment package, especially given that the company has only $19 billion in long term debt against $48 billion in total real estate assets - an exceedingly low leverage / risk ratio.

Given the present valuation edge, we see ~30% upside for O, which leads to a price target of around $70.

Alexandria Real Estate Equities

ARE is a bit 'riskier'. The company has grown revenue and cash flow consistently, alongside O, but the valuation looks a bit more stretched, and the debt profile is riskier - with only $36 billion in tangible assets vs. $11 billion in long term debt.

This isn't an issue per-se, but given that ARE is highly exposed to the under-pressure office segment, the unpredictability of future interest coverage appears higher.

Some of this is ameliorated given that life sciences offices, the kind that ARE owns, are under less stress than normal office space of professionals that can work remotely.

However, overall, combined with but the dilution which has also been strong, along with weak overall price momentum, ARE looks like the riskier play of the two.

Valuation wise, there appears to be more limited upside for ARE to get to 'fair value', which we see around 14% higher than it's currently trading. However, if multiples extend, then we could see higher prices & momentum.

Comparatively, ARE can be seen a higher-beta way of playing the macro trends discussed - more risk, but potentially more reward in the case of a strong period for Real Estate.

Risks

There are some risks with our thesis.

First, the trajectory of Real Estate's RRG trail could turn sour. Right now, we are anticipating that the position of the reading, combined with the trajectory, as well as a slowdown in macro headwinds, should lead to outperformance in 2024.

If the RRG reading flips lower due to slowing momentum or other factors, then XLRE may not outperform in 2024. This could delay the appearance of an "Improving" reading, which is what has shown to produce outperformance long term.

Additionally, rates may stay higher-for-longer. This would dampen investor spirits, and lead to more issues when it comes to the profitability of partially leveraged real estate assets.

That's why it's important to keep an eye on the CPI, which is the main factor in the Fed's underlying rate decision making. If inflation re-accelerates, then it dampens our thesis considerably.

Summary

While there are some risks, we think that XLRE, and O and ARE in particular, are well positioned to outperform the market in 2024.

Strengthening macro trends, a slowing of headwinds, and a favorable position and trajectory from an RRG perspective show that these top picks may be some of the best-performing assets of 2024.

Cheers!

Editor’s Note: This article was submitted as part of Seeking Alpha’s Top 2024 Long/Short Pick investment competition , which runs through December 31. With cash prizes, this competition -- open to all contributors -- is one you don’t want to miss. If you are interested in becoming a contributor and taking part in the competition, click here to find out more and submit your article today!

For further details see: