How Interest Rates Hurt and Then Helped Real Estate

There’s little question that higher interest rates have bedeviled real estate investment trusts (REITs).

After an extended period of near-zero interest rates following the COVID-19 pandemic, the Federal Reserve (Fed) initiated a rapid monetary tightening policy in 2021 to combat the steepest rise in inflation since the 1970s. This policy has eroded property values and increased borrowing costs.

After three years of doldrums, we believe a favorable climate has emerged for REITs.

Moderating inflation and softness in the labor market's foundation over the summer prompted the Fed to start cutting interest rates in September. However, most Fed watchers agreed at least two months ahead of time that an easing cycle was about to begin.

The prospect of an improving interest rate environment boosted real estate stocks. Real estate was the second strongest sector during the third quarter, behind utilities.¹

In a way, the elevated interest rates that troubled REITs are now helping fundamentals.

That’s because higher interest rates, which increased the cost of accessing capital, slowed new real estate development over the last three years. The result is a favorable supply-and-demand dynamic for most existing supply.

Current Real Estate Demand vs. Supply Challenges

Whether it’s senior housing or data centers, acquiring land, financing the project, obtaining permits and building a facility can take years.

And that assumes these projects can charge enough rent, given the higher construction materials and labor costs since the pandemic, to proceed with a viable plan.

This lack of supply and the delay in adding inventory means that certain types of REITs hold considerable pricing power in today’s market.

About 80% of our investible REIT universe is seeing materially lower supply growth today than at any time over the last five years. Single-family housing and data centers are notable exceptions. The data center sector is seeing record-breaking demand levels spurred by investments in artificial intelligence (AI).

Meanwhile, we feel bullish about senior housing, data centers and retail real estate.

Aging Boomers Drive Demand for Senior Housing

The pandemic was particularly troublesome for senior housing. Seniors were especially vulnerable to the severe impacts of the coronavirus, and living in close proximity increased their risk. As a result, occupancy rates fell to a low of 78%, down from 87% in the first quarter of 2020 before the virus spread widely in the U.S.²

Since then, occupancy levels in senior housing haven’t quite reached pre-pandemic levels. We expect occupancy to reach pre-COVID levels in two to three years, and at the same time, owners are raising rental rates well above inflation. Even beyond the next few years, hundreds of thousands of people each year in the U.S. will soon need senior housing, as shown in Figure 1.³

At the same time, construction of new senior housing units has dwindled, as illustrated in Figure 2. Access to and the cost of capital and labor and construction material costs are to blame for the slowdown in construction.

Construction loans have recently commanded interest rates between 9% and 10%, a significant premium over the last decade. And cost inflation has outpaced rental inflation.

These factors make it hard, financially speaking, to build new senior housing. We expect this to continue until rents catch up to the elevated cost structure of construction.

For now, the imbalance in favor of demand means senior housing owners have favorable pricing power, which benefits health care REITs.

U.S. health care REIT Welltower reported that the second quarter marked the seventh consecutive quarter of net operating income growth of more than 20% in its senior housing portfolio. Its second-quarter revenue growth in senior housing was more than 8% due to solid occupancy and rate growth. Meanwhile, lowering inflation eased expense pressures.⁴

We believe demographic trends — namely, aging Baby Boomers — should continue to favor senior housing. Industry estimates forecast a need for 806,000 additional senior housing units by 2030.⁵ A widening supply-and-demand gap should benefit existing senior housing landlords if construction activity remains muted.

How AI Electrifies Demand for Data Centers

OpenAI unveiled ChatGPT in November 2022. The large language model answered users’ questions with speedy and precise results.

It also captured the public’s imagination about how powerful advancements in AI could fundamentally reshape how the world lives and works. An astonishing wave of investment in artificial intelligence quickly followed and persists today as companies look to capitalize on and outmaneuver competitors.

One byproduct of AI is its insatiable appetite for computing power. The average ChatGPT search requires about 10 times more electricity than a Google search. AI’s computing needs rely on the availability of data centers — large, nondescript buildings full of servers, routers and other components.

As AI becomes an increasingly common aspect of everyday life, Goldman Sachs anticipates that data center demand will grow 160% by 2030.⁶

Like senior housing, developers can’t build data centers at a moment’s notice. These buildings have highly technical and specialized specifications. They often require state and local subsidies, which take time to secure. This is another scenario where the extended time horizon for building new facilities creates pricing power advantages for owners of existing data centers.

One example is Iron Mountain, a REIT best known for its document storage business but has an expanding data center segment. Its global data center business reported nearly $300 million in revenue during the first half of 2024, an almost 30% increase compared to the same period in 2023. Iron Mountain’s quarterly report cited improved pricing as a reason for the revenue growth (although adjusted EBITDA margins were down due to higher pass-through power and overhead costs).⁷

Iron Mountain CEO William Meaney discussed the company’s advantage in pricing at a conference presentation in September:

We think interest in AI is in its early innings and that demand for data centers will endure well into the coming years.

Retail Shopping Centers: Performance and Trends

Among the myriad effects of the pandemic was grocery stores' failure to open new locations. Consumers held back on spending in the initial stages of the pandemic, and government restrictions on indoor gatherings made it impractical for grocers to expand, even though they emerged as one of the better-performing retailers during the pandemic.

Then came stimulus checks meant to keep households afloat during the crisis. In the years since the pandemic eased, consumer spending has been strong, supporting the U.S. economy.

Those trends — along with retailers and grocers like Target, TJ Maxx and Kroger now opening new stores — have underpinned the strength of grocery-anchored shopping centers. Even so, supply remains below demand for retail stores. See Figure 3.

We see this property type as one of the better opportunities for retail REITs. Altus Group reported that at the end of 2023, occupancy at shopping centers anchored by a grocery store reached 92%, while occupancy at shopping centers without a grocery anchor fell below 90%.⁹

These strong leasing trends give grocery-anchored shopping centers pricing power, even with grocers and other large retailers opening new stores.

Kite Realty Group, a retail REIT focused on open-air shopping centers, is keen on grocery-anchored shopping centers.

In 2021, Kite completed a $7.5 billion merger with Retail Properties of America. This merger highlights the company’s orientation toward grocery-anchored neighborhoods and community centers, particularly in warmer and cheaper markets.¹⁰ Kite has seized on favorable supply-and-demand characteristics by continuing its focus on developing and redeveloping high-growth shopping centers.

Impact of Economic Conditions on Real Estate Dynamics

Economic shocks can disrupt the best assumptions about real estate.

We have predicted a soft landing for the economy, which has largely occurred up to this point, and we don’t think a cyclical slowdown will turn into a recession.

In such a case, we believe the favorable supply-and-demand dynamics in certain sectors will be resilient.

While a recessionary environment could change the environment for commercial real estate, we believe demand in data centers and senior housing would be relatively persistent and more insulated than other property sectors.

An economic downturn is unlikely to meaningfully change the number of aging seniors who need a place to live. Nor is it likely to cause companies to significantly abandon their AI-related plans and investments, so we believe data centers will retain strong demand.

It’s often said the first rule of real estate fundamentals is location, location, location. This adage may still be accurate, but we believe favorable supply-and-demand trends like the ones we have identified — senior housing, data centers and grocery-anchored shopping centers — carry as much weight in finding value in real estate.