With the Federal Reserve recently softening its stance on the rate of rise of its interest rate increases, the stock market has retained a good portion of the gains it’s achieved since the October 2022 bottom. As I’ve noted here many times, the homebuilder stocks have been a leading sector in the rise.

Meanwhile, in comparison the commercial real estate sector has offered mixed results. Indeed, the reasons for the good fortunes of the homebuilders and the heartburn in commercial real estate are related.

On the other hand, recently released hotter-than-expected retail sales and a lateral moving consumer price index (CPI) have once again unsettled the stock market, as fears resurface that the Fed will once again increase the pace of its rate hikes.

The problem for the Fed is that inflation is a symptom of a much larger trend, the “Great Migration.”

The Big Picture

Let’s briefly recap. The COVID pandemic triggered a two-step migration. Initially, the movement was from big cities to suburbs. But as the pandemic progressed, “blue” states remained closed longer than “red” states. This triggered a second migration from the aforementioned blue states such as California and New York, to the red states. Generally, states in the southern U.S. re-opened sooner than the blue states, in turn offering employment opportunities and lower cost housing.

Florida and Texas were huge beneficiaries of this migration. Arizona, Georgia, and North Carolina were not far behind. Recent reports suggest that this trend is far from over, and may actually accelerate.

Meanwhile, the geopolitical situation has changed drastically. Never mind the balloon saga in the news. Instead consider the fact that commerce between China and the U.S. is rapidly decreasing as a result of China’s COVID-related prolonged shutdowns as well as the evolving situation in Ukraine.

All of these factors have led to American corporations bringing trade back to the U.S. and neighboring regions, a phenomenon known as “onshoring,” whereby plants and businesses are relocated to the U.S. “Friend-shoring” is another trend, whereby trade moves to other, friendly countries. Some are in Asia such as Thailand and Vietnam, while others are in South America, such as expansions of factories in Mexico.

Many have simply moved South. Toyota (NYSE: TM), JPMorgan (NYSE: JPM), and Tesla (NSDQ: TSLA) now call Texas home, or have expanded their presence there. Goldman Sachs (NYSE: GS) is making a move toward Dallas in the not-too-distant future. Citadel left Chicago for the warmer climate and lower taxes of Florida.

The migration south has spawned a homebuilding boom and commercial warehouse and office building explosion in the southern U.S., while both commercial and residential real estate in the “blue” states have stalled.

Certainly, there is plenty of nuance since there is no uniformity in the rate of ascension or decline in any locality. So when we discuss the “blue” vs. “red” situation, it should be noted that there are plenty of areas in each general geographic region which are doing well or hanging on while each region has its share of areas that are stalling or crashing.

The net effect is the same. The migration is ongoing and long-term trends such as supply chain disruptions favor its continuation.

Let’s look at both residential real estate, in contrast to commercial real estate, via the lenses of the stock market.

Homebuilders Remain in Positive Momentum Thrust

The real question for investors is whether the housing boom and the better performance of housing in the south versus other regions is good enough to keep homebuilder stocks moving higher. The answer, so far, is yes.

In my own region, the Dallas Fort Worth metroplex (DFW), I saw a fairly meaningful slowing of the housing market during the fall and early winter of 2022. I described the situation here, where I concluded: “The question for investors is whether the need and urge to move will overshadow the Fed’s influence on stocks, which would benefit from the migration surge. If indeed it does, we can expect to see stocks such as BLD and ETFs such as XHB outperform the general stock market over the next 12-18 months, even as the Fed raises rates.”

So far, I’ve been correct. Even though my homebuilder contact has not brightened up much, other builders in the area are doing just fine. A weekend walk through a nearby development from a large local builder that opened its doors last summer showed me that almost 1/3 of the lots have either “SOLD,” or “Pending” signs while the number of houses being framed and heading toward finishing is rapidly rising. I expect to see people moving in within a few weeks.

Moreover, the model home often has five or six cars parked in front of it on weekdays. On the weekends it’s often more. The place is so busy, you’d think mortgage rates would be near zero. A recent review of Zillow listings in my neighborhood surprised me as well priced existing homes are starting to sell as well.

The bellwether homebuilder stock, DR Horton (NYSE: DHI), remains in a robust uptrend. But it’s not alone with most other publicly traded homebuilders sporting similar price charts. I featured the price chart for mobile homebuilder Skyline Champion (NYSE: SKY) in a recent post about small-cap stocks. The stock is still near its recent highs with strong Accumulation Distribution (ADI) and On Balance Volume (OBV). Both are signs that money is still moving into the shares.

Commercial Bellwether Sneezes

The commercial market is a bit more nuanced. Warehouses are popping up everywhere in the south, and tenants are actually sprouting up, albeit slowly. On the other hand, office buildings continue to move toward finishing while new “Coming Soon” signs are no longer a novelty. It’s difficult to gauge whether tenants will materialize.

Interestingly, the news in areas like Chicago and San Francisco offers a different tone. For example, the likely bankruptcy of retailer Bed Bath and Beyond (NSDQ: BBBY) is starting to trickle toward its landlords, such as Starwood Property Trust (NYSE: STWD).

Starwood, run by the highly regarded Barry Sternlicht, is the largest publicly traded real estate investment trust on the NYSE. As a result, what happens to them is important.

Specifically, STWD has been having problems with its malls in Chicago. In this instance, BBBY’s store closure leaves STWD with a pending $77 billion dollar loan. The loan had to be renegotiated as STWD couldn’t make the scheduled payment in July 2022. Moreover, according to the Real Deal.com website:

“The firm lost control of the Louis Joliet Mall in October 2021, turning it over to a lender after defaulting on payments for an $85 million mortgage on the property. In June, Starwood lost the Arboretum of South Barrington after defaulting on a $67 million loan, two months after losing the Promenade Bolingbrook shopping center.”

Starwood Property Trust is an affiliate of Starwood Capital, which has many other affiliates. Thus, the evolving situation in Chicago may not be directly related to STWD, and because of the backing from the mothership, the REIT may be able to hang on through some difficulties.

My point is that commercial real estate is facing some interesting headwinds. First, the Great Migration is clearly affecting regional holdings in “red states” along with the business cycle and the Fed’s rate hikes. Specifically, mall traffic has yet to fully recover after COVID. In addition, the loss of a big tenant such as BBBY, even if corrected, will have some negative effects on rent collections. When you add the losses brought on by office tenants moving operations to the south, things get a bit more precarious. Without tenants, it’s hard to make mortgage payments.

Second, if one or more Starwood related entities eventually defaults in a major way, the repercussions will be felt far and wide as creditors will start to wonder if that entity is the only entity in the group that’s in trouble.

Given Starwood’s debt driven business model, things could get interesting.

Note the difference in the price charts between the two homebuilders above, DHI and SKY and STWD, which is lagging. Moreover it remains below its 200-day moving average while its own ADI and OBV are starting to sag.

Bottom Line: Buyer Beware

When investing in real estate it pays to dive deeply into the macro and micro details of where you’re putting your money.

In the current market, homebuilders seem to be offsetting the weakness in the blue states better by selling houses in the red states. They seem to be faring better than commercial entities who are faced with similar challenges. This is likely due to the persistent undersupply of adequate or appealing housing to those moving to the new regions while the migration has led to a glut of commercial real estate vacancies.

On the other hand, there is plenty of supply for office buildings and warehouses in both red and blue states.

As a result, it’s plausible that the big bets made by commercial real estate entities in red states may or may not pan out. There are no guarantees that warehouses in the south will boom any time soon either. All of which begs the question as to whether the Federal Reserve really understands the effects of its “higher for longer” posture when it comes to interest rates while the single most important long-term trend, the Great Migration, continues to unfold.

I own shares in DHI and SKY in my private account.

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Dr. Duarte has been a professional investor and independent analyst since 1990. He is a former registered investment advisor and author of the bestselling Options Trading for Dummies, and several other books including Market Timing for Dummies and Successful Biotech Investing.

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