Every day I read reports which tell me yet another commercial real estate (CRE) default has occurred. There aren’t many investors left who aren’t aware of the CRE problems in San Francisco, Chicago, Los Angeles, and New York.

Yet, of late, I’m seeing that markets formerly considered to be “strong and resilient,” like Austin, Houston, and Dallas, are struggling. Meanwhile investors are reacting negatively to the volatility in the bond market and the ensuing short-term trends in real estate.

However, a review of key real estate investment sectors, and 36 years as a stock trader, tell me that the current turmoil will benefit the largest and best financed players in the sector. Moreover, investors who recognize this emerging trend early are likely to profit.

Of course, I’m not downplaying the negative short and intermediate term effects of rising interest rates on all stocks, especially interest rate sensitive sectors such as homebuilders and real estate investment trusts (REITs). And yes, the Federal Reserve has the power to wreck the economy; and may do so if the stars line up just right for that to happen.

But there’s more nuance to the situation than meets the eye, especially over the longer term. And maybe the Fed is done raising rates, especially after recent consumer price index (CPI) data which suggests that inflation may have peaked.

READ THIS STORY: Latest CPI Report Spells The End of Tightening as We Know It

Real estate has two macro sectors: commercial and residential. Each sector has multiple sub-sectors.

Moreover, all real estate responds to three environmental factors: location, interest rates, and supply. Although everyone focuses on interest rates, few investors consider the effect of supply on the market.

My point is that even when interest rates are high, if there is a shortage of space, those who control the supply are in the driver’s seat. Low supply in better locations increases supply shortages.

Take the residential side of the equation. There are homes for sale and for rent. Furthermore, there are single family homes, apartments, condos, and townhomes. Digging further into the dynamic we also find spare rooms for rent, backyard sheds, mobile homes and tiny houses.

There are essentially three types of single family homes: new and existing homes for sale, and homes for rent. You can invest in each category via homebuilders, real estate brokers, or REITs holding rental properties that are hybrids between commercial and residential properties.

In the world of CRE, there are multiple asset classes, ranging from farmland to office buildings, with retail establishments of many sorts (strip malls, destination malls, etc.) to warehousing (self-storage, commercial storage, supply chain related and multiple others) in between.

Recent Developments

Prior to the release of the encouraging CPI numbers on 7/12/23, the U.S. Ten Year Note yield (TNX) had risen above 4% as investors fretted about the Federal Reserve’s promised resumption of its rate hike cycle after the central banks’ pause in June. Prior to the pause, TNX had been falling and homebuilder stocks delivered another up leg in what, as best as I can tell, is an ongoing secular bull market.

Frequent readers of my articles, and subscribers to my premium service, Profit Catalyst Alert, are familiar with my bullish stance on homebuilders for the past few years. Now, and contrary to what would be expected, there is money flowing into REITs, suggesting we may have already seen the bottom for certain areas of commercial real estate.

And yes; I know that sounds a bit hyperbolic. But when stocks rise in the face of bad news, no matter how awful the news, it’s a sign of a bottom.

Specifically, I’m referring to two sub-sectors in the REIT universe: warehousing/storage, and apartment and single home rental REITs which can manage their debt load.

Dividing and Conquering

Because of the uncertainty in the marketplace, investors who take a contrarian approach and put in the time to look at individual subsectors of real estate are more likely to be rewarded. Here is what I mean.

For homebuilders, whose shares have been on a major momentum run for the past eight months, sellers took the early July rise in bond yields, combined with a steep decrease in weekly mortgage activity as an excuse to sell the shares.

But the market can change rapidly. As soon as bond yields rolled over, homebuilder shares, as in the SPDR S&P 500 Homebuilders ETF (XHB) rebounded. Thus, dips that are often worth buying appear with some frequency.

REITs, on the other hand, barely budged on the rise in TNX during the past few weeks. That’s a reliable sign that a bottom is forming.

The CRE news is often frightening. You hear that office buildings are going into default as the lack of renters is making it impossible for the owners to make their debt payment. Yet, the action in Digital Realty (NYSE: DLR), a REIT which owns data centers, those buildings where AI and data crunching programs live, recently broke out:

You can certainly argue that DLR is riding the AI wave but that other areas of the REIT sector are dying. Yet, the chart for the iShares U.S. Real Estate ETF (IYR), which owns shares in the entire spectrum of REITs, ranging from office building to warehouses, says otherwise.

In fact, IYR is slowly breaking out of a multi-month basing pattern as short sellers, displayed by a bullish rise in the Accumulation Distribution Indicator (ADI), are bailing out.

A Nation of Market Timers

Over the past year, rising bond yields lead to a pullback in homebuilders. Yet, as soon as bond yields roll over, homebuilder stocks rebound.

That’s because the market realizes the migration to the sunbelt and to areas of states with jobs and lower crime rates along with structural changes to supply chains and the subsequent regionalization of commerce are not likely to abate anytime soon.

In addition, consumers and real estate brokers have become market timers. They wait for the bond market to roll over so they can get the best possible mortgage rate and pull back their horns when market rates rise.

All of which means that higher interest rates only slow or postpone people’s intentions, whereas their basic need to move to an area where they have better living conditions is not altered.

Where Interest Rates, Supply and Demand, and Logistics Meet

I could be wrong. After all markets can change directions at the drop of a hat.

Yet, given the way money is flowing into residential and commercial real estate suggests a bullish turnaround in the sector is close at hand.

Interest rates offer temporary turbulence to markets. But the long-term influences remain unchanged. The major and very secular influence on real estate is the combination of low supplies in living spaces, ongoing population shifts, and the relocation of critical supply chain and storage components as the supply chain gets reconfigured.

The Fed can’t change any of that forever.

Therefore, homebuilders will continue to build just enough houses to meet the demand required to remain profitable. REITs which specialize in warehousing, supply chain management, and apartment rentals, and can manage their debt, will increase their market share by gobbling up properties and bankrupt competitors on the cheap.

And when the Fed finally stops raising rates, or is forced to lower them, mortgage rates will drop along with bond yields and the cycle will accelerate.

The market is betting on this scenario which is why homebuilder stocks are not breaking down after a huge bull run, and REITs are starting to attract money. I agree with the market.

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