After a tremendous performance in 2021 as the world gradually normalized from the COVID-19 pandemic, the real estate sector has been a major laggard in the years since.

In the 2022 bear market where the S&P 500 produced a total return of negative-18%, the real estate sector's performance was eight percentage points worse. It then proceeded to underperform by about 14 percentage points in the 2023 rebound and by another 20 percentage points in 2024. In all, since January 2022, the S&P 500 has returned 29% to investors, while the real estate sector is down by 13.5% over that three-year period, even including dividends.

However, there's good reason to believe that 2025 will be an inflection point. That's why I've been investing in the Vanguard Real Estate ETF (VNQ 0.22%) in my own portfolio, and why it could be worth a look for yours as well.

Real estate's dismal performance

One key point to know is that the businesses of most real estate investment trusts, or REITs, are doing quite well, despite what their stock performance might suggest.

As an example, leading freestanding retail REIT Realty Income (O -0.30%) reported adjusted funds from operations of $3.14 per share through the first nine months of 2024. That's 19% higher than in the comparable period from three years ago, when the stock was trading for about 33% more than the current price.

The main problem is the interest rate environment. Interest rates started rising in 2022 and continued to increase in 2023, and the Federal Reserve's rate cuts were slower than initially expected in 2024. Real estate is perhaps the most interest rate sensitive sector in the market, and for three main reasons:

1. REITs rely on borrowed money to a greater extent than other sectors, and rising rates makes it more expensive to borrow.

2. REITs are dividend-focused investments with stable cash flows, and their shares tend to come under pressure as income investors rotate money into risk-free assets like Treasury securities when rates rise.

3. The market values of the properties REITs own are highly dependent on the interest rate environment. Without turning this into an economics lesson, when yields on risk-free investments rise, investors expect yields from higher-risk investments, such as commercial properties, to rise accordingly. Since yield and price have an inverse relationship, rising rates put pressure on property values.

An inflection point?

As mentioned, the timing and the pace of the Fed's rate cuts weren't as aggressive as many had been expecting, and the same can be said for the forecast as we head into 2025. The median expectation priced into the market is for just a single quarter-point rate cut in 2025, down from expectations for four cuts just a couple of months ago.

However, the consensus remains that we'll be in a falling-rate environment for the foreseeable future. There could be political pressure from the incoming Trump administration when it comes to lowering rates, as there certainly was during his first term. And there's significant economic uncertainty right now, which could cause the Fed to err on the side of lower rates as the year goes on.

I recently wrote an article of bold predictions for the stock market in 2025, and one of them is that real estate will be the best-performing S&P 500 sector. Whether or not that ends up being true, it still looks like an excellent time to add real estate exposure from a long-term perspective.

The Vanguard Real Estate ETF invests in a weighted index of REITs, with top positions that include Prologis (PLD -0.33%), American Tower (AMT 0.05%), and data center giant Equinix (EQIX 0.90%), just to name a few. It has a low 0.12% expense ratio and could be a great way to get real estate exposure without being too reliant on the performance of any individual company.