Real Estate Weekly Review
The REIT ETFs (VNQ and IYR) finished the week lower by 3%, erasing the 1% gain last week, resuming a post-tax-reform slide that has seen the REIT index retreat to levels last seen in early 2016. The 10-year yield surged 18 basis points, reaching the highest level in more than three years as investors expect upward pressure on economic growth, wages, and inflation due to the tax reform package. The S&P 500 (SPY) dipped nearly 3% this week while homebuilders (XHB) finished the week lower by 6.1%. Mortgage REITs (REM) dipped 4.5% while international real estate (VNQI and RWX) declined 3.7%.
(Hoya Capital Real Estate, Performance as of 12pm Friday)
While uncorrelated over the long-term, REITs tend to become highly interest-rate-sensitive during periods of heightened interest rate volatility. Ultimately, inflation expectations (not Fed policy) drive movements in the 10-year yield. Interestingly, as we've pointed out, much of the inflation in recent years has come from rental housing. At the margins, however, energy prices tend to drive changes in inflation expectations. The price of oil will likely determine the path of inflation (and the 10-year yield) in 2018.
This week, we published a report Time Is Different that looked at current valuations and past patterns exhibited by REITs during periods of fears over rising interest rates. We pointed out that REIT valuations, as measured by FCF (AFFO) multiples, have retreated to post-recession lows. The past three times this has occurred were ultimately lucrative buying opportunities. Will this time be different?
Within the Equity Income categories, we note the performance and current income yield of the Utilities, Telecom, Consumer Staples, Financials, and Energy. Within the Fixed Income categories, we look at Short, Medium, and Long Term Treasuries, as well as Investment Grade and High Yield Corporates, Municipal Bonds, and Global Bonds.
Through one month of 2018, REITs are now lower by 6.8%, significantly underperforming the US equity markets which have climbed 4.5%. The 10-year yield has climbed 44 basis points since the start of the month.
REITs ended 2017 with a total return of roughly 5%, lower than its 20-year average annual return of 12%. Going forward, absent continued cap-rate compression, it is reasonable to expect REITs to return an average of 6-8% per year with an annual standard deviation averaging 5-15%. This risk/return profile is roughly in line with large-cap US equities.
Real Estate Earnings Season
Earnings season resumed this week in the real estate sector and will continue for the next four weeks. Last week, we published our Fourth Quarter Real Estate Earnings Season Preview.
Reporting this week was Equity Lifestyle (ELS), Alexandria (ARE), Boston Properties (BXP), Equity Residential (EQR), Simon (SPG), AvalonBay (AVB), Duke (DRE), Eastgroup (EGP), Mid-America (MAA), Kilroy (KRC), Camden (CPT), Aimco (AIV), DCT Industrial (DCT), and Kite (KRC). We updated the earnings calendar below. We will analyze the earnings reports in our forthcoming REIT Rankings updates.
The tech and industrial sectors were again the best performers of the week. Duke, Crown Castle (CCI), SL Green (SLG), Equinix (EQIX), Public Storage (PSA), and Prologis (PLD) were among the best performers.
The yield-sensitive sectors continue to be hit by interest rate pressure and shopping centers were particularly weak. Pennsylvania REIT (PEI), Acadia (AKR), Tanger (SKT), Kimco (KIM), Brixmor (BRX), and National Retail (NNN) were among the worst performers.
Real Estate Economic Data
(Hoya Capital Real Estate, HousingWire)
Labor Market Continues to Exceed Expectations
Broad-based strength in the labor markets continued in January as nonfarm payrolls rose 200k, beating the expectation of 184k. Earlier in the week, ADP data showed a rise of 230k, also beating expectations. Across all labor market metrics, the pace of hiring has slowed only modestly despite signs of tightening labor markets. ADP data continues to show a 2% expansion of the workforce while BLS data shows that hiring has slowed from the 2% rate in 2016 to 1.5% in January.
Average hourly earnings were higher than expected, rising 2.9% which was the fastest pace of wage growth since 2009. This unexpected uptick jolted markets, sending yields higher as investors expect higher rates of inflation going forward, a sharp break from the "Goldilocks" economy that had been powering financial markets higher.
While the inflation-specific data has yet to show any real uptick, inflation expectations have surged higher in recent weeks after the passage of tax reform. The 10-year breakeven inflation rate jumped above 2.2% after the jobs report despite the most recent Core PCE data showing 1.5% inflation and Core CPI showing 1.8%. Higher inflation expectations have been primarily responsible for the surge in the 10-year yield.
Made in America: "Goods-producing" sectors have seen a dramatic resurgence since the election. Manufacturing jobs, which had entered a mild recession in 2016, have seen significant growth in recent quarters. Jobs growth in the goods-producing sectors grew 2.4% from last year. On the other hand, the services sectors, which account for 85% of the economy, have been slowing. Services employment rose just 1.3% from last year, dragged down by retail layoffs.
The unemployment rate remained at 4.1%, but the prime working-age labor force participation rate remains stubbornly low and remains nearly 300bps below the 2000 peak, representing more than 3 million able-bodied prime-working aged Americans that are not seeking work relative to 2000-levels. Another measure of labor force participation, the OECD's Activity Rate, shows a dramatic trend in the decline of the male prime-working-age activity rate, plunging from 96% in the 1960s to 88% in 2017.
In all, more than 20 million Americans aged 25-54 are not in the labor force. There are several common explanations for the sustained decline in prime-working-age male labor force participation: high incarceration rates, the expansion and abuse of government benefits programs, opioid usage, and longer time spent in the educational system. Structural reforms may be needed to fully unleash that segment of the workforce. If this can be accomplished, we believe this suggests further slack in the labor markets and continued modest pressure on wage growth.
Construction Spending Continues to Moderate
Construction spending data came in slightly below expectations after downward revisions to prior months, continuing a trend of moderating growth in private sector construction. Residential construction spending remains the bright-spot despite moderating growth, growing 10.6% on a TTM basis. Private nonresidential construction has slowed significantly, rising just 0.6% TTM while public spending remains in negative territory on a TTM basis.
After several years of above-trend supply growth, all of the major nonresidential commercial real estate have seen slowing construction activity. Tighter financing conditions, higher construction costs, and moderating asset valuations have sidelined incremental projects.
If we are indeed at or near the end of this construction cycle, it's fair to say that supply growth was more moderate than past cycles. Overbuilding in the 2000s was a contributing factor to the "bust" in commercial real estate valuations during the financial crisis. After adjusting for construction inflation, real construction spending remains significantly below the peak of the prior cycle.
Home Keep Rising… But Tax Code & Higher Rates May Disrupt The Trend
The major home price indexes outpaced consensus expectations in 2017 and continue to show a steady 5-7% YoY rate of appreciation. Home prices have risen at least 5% YoY in every month since late 2012. The Case-Shiller national index showed 6.4% YoY growth in November, up from 6.3% in the prior month. National home prices are now 6% above peak levels on a nominal basis but remain 13% below peak levels after adjusting for inflation.
Home prices have defied the downward pressure in rental growth as multifamily supply growth has equalized market conditions after several years of robust rent growth. We think 2018 may finally be the year that home price appreciation moderates, sparked by changes in the tax code and potentially higher mortgage rates. The consensus economist projection calls for a 4.5% in home prices. We'd "bet the under" as we believe it's reasonable to expect home price appreciation to slow to 2-4% by the end of 2018, roughly in-line with apartment rents. Considering the lag in home price data, we may not see these effects until early 2019.
Between 1993 and 2010, household formations lagged housing completions by 5 million units. This period of overbuilding was a central cause of the housing crash. Housing construction has seen a grindingly slow recovery since 2010, which has allowed the oversupply to be gradually absorbed. The pendulum appears to have swung as housing demand is now exceeding housing supply on a rolling 5-year basis.
REITs resumed their post-tax-reform slide this week, dipping 3% as the 10-year yield surged to levels last seen in early 2014. REITs have dipped 10% since tax reform passed Congress. Homebuilders are beginning to feel the pain of higher rates as well, sliding more than 6%. Mortgage rates have shot higher in recent weeks, further threatening housing affordability.
The US economy added 200k jobs in January, beating expectations. The unexpected uptick in hourly earnings to 2009-levels, however, jolted financial markets as inflationary fears have emerged. Tightening in the labor market threatens to derail the recovery. Structural changes are needed to unlock the nearly 20 million prime-working-age (24-54) Americans that remain out of the workforce.
We recently we updated our international real estate report: Worried About Rising Rates: Go International. Investors have soured on income-oriented sectors as global economic growth has picked up. US REITs have been hit this year by fears of rising rates. Investors interested in reducing their portfolio's interest rate risk should consider increasing their allocation to international real estate.
For further analysis on all fifteen real estate sectors and how they all stack up, be sure to check out all of our quarterly updates: Hotel, Cell Tower, Single Family Rental, Industrial, Healthcare, Apartment, Mall, Net Lease, Data Center, Shopping Center, Manufactured Housing, Student Housing, Office, and Storage sectors.
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Disclosure: I am/we are long VNQ, SPY, MAA, CPT, OHI, PLD, GGP, STOR, SHO, SUI, ELS, ACC, EDR, DLR, COR, REG, CUBE, PSA, EXR, BXP, EQR, INVH, SPG, HST, TCO, AMT, SBRA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: All of our research is for educational purposes only, always provided free of charge exclusively on Seeking Alpha. Recommendations and commentary are purely theoretical and not intended as investment advice. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. For investment advice, consult your financial advisor.