The Real Estate Select Sector SPDR® Fund ETF (NYSEARCA:XLRE) is finally all set to rebound after more than two years of underperformance triggered by the Fed’s tightening. The rebound is likely to be driven by improving earnings growth power and the potential rate cuts. Moreover, the share price underperformance in the past years combined with improving earnings growth outlook slashed its forward valuations significantly below a recent record high. Therefore, I maintain my buy rating on XLRE.
The Real Estate Sector is Rebounding
After two years of underperformance, the real estate sector has finally begun rebounding at a solid pace. This is reflected in XLRE’s share price rally of 18.5% since mid-April, outperforming the S&P 500 index by 8%. The percentage of outperformance increased in the past month because of increasing hopes over the Fed rate cut and solid financial performance.
After increasing rates at a robust pace and keeping them at a peak level in the past four quarters, the Fed now appears to be in a position to slash them from the next month. Key data used in setting the interest rate policy, such as inflation and unemployment, plunged to the lowest level since early 2021. For instance, inflation declined below the 3% level for the first time since March 2021 while the unemployment rate soared to 4.3% after hovering around the 3.4% range in the last two years. CME data suggest a 67% chance for a 0.25% rate cut in September and a 36% probability for a 0.50% reduction from a peak level. Moreover, another rate cut is also expected later in 2024 and multiple cuts in the following year. Furthermore, the recent job growth data has raised concerns over the potential recession and hard landing. In the case lower than expected job growth reports in the coming months, the Fed may increase size of rate cuts to avoid a recession.
Besides the potential rate cuts, higher than expected earnings growth recovery is likely to be a key catalyst for a share price rebound. According to the FactSet data, 84% of companies in the real estate sector topped expectations, marking the second-best performance among the S&P 500 sectors. The sector’s earnings grew 4.3% and revenue jumped 7.1% compared to expectations for a 2.3% and 6.3% increase, respectively. Wall Street expects earnings growth of nearly 7% for the third quarter, representing a significant growth from the previous quarter. Overall, the potential rate cuts are likely to improve activities in the sector while lowering the interest rate costs. Furthermore, the sector also appears attractive based on valuations because it is currently trading below its 5-year average. The sector’s current forward PE of 38x is down from 2022 record of 55x and pre-pandemic level of 45x.
XLRE Could be an Attractive Option
The Real Estate Select Sector SPDR® Fund ETF appears to be one of the best investment options to capitalize on the potential rebound. This is because of its portfolio structure, high dividends, low expense ratio and robust liquidity. Excluding mortgage REITs, XLRE portfolio offers a targeted exposure to the rest of industries in the real estate sector. Although the number of stocks holdings is small with a significant concentration in the top 10 holdings, a diversification factor across various industries is high. For instance, specialized REITs represent nearly 43% of its portfolio weight while industrial, residential, healthcare, and retail REITs each hold a low double-digit percentage weight.
The ETF held a stake in 31 companies, with top 10 holdings accounting for 60% of the overall portfolio. Its top 10 holdings include prominent names, such as Prologis (PLD), American Tower (AMT), Equinix (EQIX), Welltower (WELL), Simon Property (SPG), Realty Income (O) and a few others. XLRE’s top holdings’ latest financial results and financial outlook highlighted improved fundamentals for the real estate sector.
For instance, Prologis topped the second quarter revenue and earnings estimate and lifted its low-end of full-year FFO outlook to $5.39 from previous estimate of $5.37. The average consensus estimate is $5.41 per share. In addition, the company’s average FFO guidance of $5.98 per share for 2025 also reflects a double-digit percentage growth from the 2024 forecast. Prologis plans to invest heavily on acquisitions and development activities in the coming quarters to meet the demand. In the earnings call, its CFO highlighted confidence in market conditions. Here is what he stated:
The bright spot continues to be the depletion of the supply pipeline and successive quarters of very low development starts. We believe we are near peak vacancy and this dearth of new supply is setting the stage for more favourable conditions in 2025. As evidenced by very strong rent change this quarter, our lease mark-to-market is serving to sustain meaningful growth through this transition.
American Tower, the second-largest holding in XLRE portfolio with a weight of 9.45%, has also increased its full-year outlook after better than expected second quarter results. The company anticipates adjusted FFO per share in the range of $10.48-$10.72, up from the previous guidance of $10.30-$10.53. Equinix, a leader in global colocation data centres, topped revenue, and earnings in the second quarter and increased its mid-point full-year adjusted FFO guidance. XLRE’s other top 10 holdings, including Welltower, Simon Property Group, and Extra Space Storage (EXR) have also raised their full-year outlook. Meanwhile, Realty Income, Digital Realty Trust (DLR), Crown Castle (CCI) maintained their full-year outlook. Out of the top 10 holdings in the XLRE portfolio, only Public Storage (PSA) lowered its full-year outlook.
XLRE received a quant score of 4.26 with a buy rating based on Seeking Alpha quant system, which is in-line with my fundamental analysis. Its momentum factor received an A-plus grade, up significantly from D-plus grade three months ago. Technically, stocks or ETFs with strong momentum are deemed to perform well in the future. Moreover, Oppenheimer estimates that around 85% of REIT stocks breached their 200-day average, which means the broadening strength and reflects improving investor confidence on fundamentals across the sector.
XLRE’s expense ratio of 0.09% is below the majority of its peers. The expense ratio of First Trust S&P REIT Index Fund ETF (FRI) and iShares Cohen & Steers REIT ETF (ICF) is 0.50% and 0.33%, respectively. XLRE’s dividend factor earned lower grade because the fundamental challenges last year impacted its cash returns. Despite that, its dividend yield of 3.14% is up from peers. The risk factor is always in the real estate sector because of its sensitivity to the broader economic and monetary conditions. Nevertheless, XLRE is one of the largest real estate ETF given its $7.53 billion in assets under management and 5.64 million shares in trading volume.
Risk Factors to Consider
While prospects for XLRE share price rebound are high, it is crucial to look at a risk factor. The sector is highly sensitive to interest rates and economic trends. In the case of a further delay in a rate cut, the real estate sector rebound is likely to be limited and its earnings growth forecasts could decline. Slow economic growth or recession is also likely to negatively impact activities in the real estate sector. Furthermore, tail-events, including geopolitical tensions, pandemic, or other unexpected events can also hinder real estate performance.
In Conclusion
Investing in a stock or ETF before a significant event can help investors earn significant gains. One such potential opportunity is currently appearing in the real estate sector because of the expected rate cut in the next month. Moreover, the robust earnings growth outlook is also likely to contribute to the potential upside. Furthermore, it is also prudent to lower the risk factor associated with a single stock investment by considering The Real Estate Select Sector SPDR® Fund ETF. XLRE offers targeted exposure to the top-performing companies in the real estate sector. Its share price momentum, expense ratio, liquidity and dividend yield are above the majority of its peers.
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