Real Estate Rally Continues After Impressive Earnings

Summary

• Following their best week since 2016, REITs jumped another 2% this week as earnings continue to beat expectations. Roughly 95% of REITs raised or maintained 2018 guidance.
• Industrial, hotel, and retail REITs have been the winners of this earnings season. Fundamentals appear to have finally bottomed in the beleaguered retail space after a brutal 2017.
• Job growth has accelerated since mid-2017, reversing a multi-year slowdown attributable to tightening labor market conditions. Deregulation and corporate tax reform appear to have added another leg to the recovery.
• Wage growth has been more moderate than expected even as the unemployment rate dipped below 4.0%. Nearly 20 million prime-working aged Americans remain on the sidelines, a source of continued slack.
• While overall inflation remains moderate, pockets of inflation have emerged in recent years. Construction costs are expected to rise more than 5% in 2018, adding to the slowdown in construction activity.

Real Estate Weekly Review

Following their best week since 2016, the real estate ETFs (VNQ and IYR) climbed another 2% this week and homebuilders (XHB) climbed 0.7%, both outperforming performance of the S&P 500 (SPY). Strong earnings across the REIT and homebuilder sectors have alleviated many concerns over interest rate sensitivity and moderating fundamentals. Roughly 95% of REITs raised or maintained 2018 guidance and homebuilder earnings were similarly strong.

(Hoya Capital Real Estate, Performance as of 3 pm Friday)

Across other areas of the real estate sector, mortgage REITs (REM) jumped more than 3% as the 10-Year yield finished the week unchanged. International real estate (VNQI) declined modestly. In the commodity and currency space, crude oil (USO) jumped more than 2% on the week, offset by a 2% decline in natural gas (UNG) while the US dollar (USDU) jumped more than 1%.

Real Estate Earnings Update

Earnings misses and downward revisions to guidance were a prevalent issue across the real estate sector in 2017. REITs that missed estimates were punished by investors, impairing their cost of capital and adding further operational challenges to their business. Entering 2018, REITs were reluctant to make the same mistake again, reflected in very conservative guidance provided at the end of last year.

So far in 1Q18 earnings season, REITs have easily surpassed this conservative guidance. With more than three-fourths of the sector having reported earnings, nearly 60% of REITs beat FFO estimates while just 7% came in short. More impressive was the 40% of REITs that raised full-year guidance with just 2 REITs lowering 2018 expectations. Industrial, hotel, storage, and retail REITs have been the winners this earnings season.

Retail REITs continue to be the standouts with solid results from Federal Realty (FRT), Acadia (AKR), Regency (REG), and retail-focused net lease REIT National Retail (NNN). Last week, mall REITs Simon (SPG), CBL (CBL), and Washington Prime (WPG), as well as shopping center REITs Kimco (KIM), Weingarten (WRI), and DDR (DDR) all raised full-year guidance, bucking the trend of downward revisions that plagued these stocks in 2017

Investors in cell tower REITs continue to digest the impact of the proposed T-Mobile (TMUS)/Sprint (S) merger. This week, we published Cell Tower REITs: Analyzing The Impact of the Proposed Merger. If the merger does indeed get approved, we expect cell tower REITs American Tower (AMT), Crown Castle (CCI), and SBA Communications (SBAC) to see a net benefit over the next half-decade from increased network investment.

Industrial REITs continue to be the standout as six out of the seven names that have reported this quarter have smashed through expectations. Storage REITs have also reported strong results with Extra Space (EXR), and Life Storage (LSI) reporting solid numbers this week following strong results from Public Storage (PSA) and CubeSmart (CUBE).

Apartment REIT earnings have generally been in line with expectations as Essex (ESS) and Mid-America Apartment (MAA) each reported solid earnings following AvalonBay (AVB), Equity Residential (EQR), and UDR (UDR) results from last week. Single-family rental REITs and manufactured housing REITs, however, continue to exhibit the more favorable fundamentals within residential REIT sub-sector.

Earnings season will continue next week and wrap-up by May 14. Results next week include Realty Income (O), Aimco (AIV), Equity Commonwealth (EQC), National Health (NHI), Lexington (LXP), and Urban Edge (UE).

DCT Industrial (DCT) was the top performer on the week after Prologis (PLD) announced an $8.4 billion acquisition of the high-quality logistics REIT which will further solidify Prologis' position as a logistics real estate titan. Other top-performing REITs included STAG Industrial (STAG), Sabra Health (SBRA), Welltower (HCN), Iron Mountain (IRM), Spirit (SRC), and National Retail (NNN).

Despite solid earnings, data center REITs were among the worst performers on continued concerns over the competitive dynamics within the industry relative to hyperscale cloud operators. Equinix (EQIX), Digital Realty (DLR), and CoreSite (COR) were among the weakest performers this week.

2018 Performance

REITs are now lower by 7% YTD, significantly underperforming the S&P 500, which is down 0.5% on the year. Homebuilders are off by more than 10%. The 10-year yield has climbed 55 basis points since the start of the year, aided by the 17% climb in the price of crude oil.

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 Economic Data

(Hoya Capital Real Estate, HousingWire)

Labor Market Continues to Exceed Expectations

Evidence of broad-based strength in the labor markets continued to show in March with few signs that the labor market has significantly tightened. The BLS reported a 164k rise in employment which, combined with the upward revisions from prior months, was roughly in line expectations. Earlier in the week, ADP reported a 204k rise in employment, beating expectations. Overall, the pace of hiring has actually accelerated since mid-2017, reversing a multi-year slowdown that many analysts attributed to tightening labor market conditions. Deregulation and corporate tax reform appear to have added another leg to the labor market recovery, which is already the longest on record at 91 straight months of job gains.

Investors remain keenly focused on average hourly earnings data for signs of tightness in the labor markets, which would generally be expected at the late stages of the economic cycle and would typically precede a slowdown in hiring. Wage growth is a positive for the US economy and corporate earnings when it results from productivity gains, but wage growth attributable to tight hiring conditions or government mandates is generally inflationary and results in higher interest rates and downward pressure to real economic growth. Average hourly earnings rose 2.57% in March (2.60% for production/nonsupervisory) which was below expectations and signals that wage pressure remains modest.

Made in America? Goods-producing sectors have seen a dramatic resurgence since late 2016. 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 2.6% over last year, which is within 30 bps of the multi-decade high in 2014. On the other hand, the services sectors, which account for 85% of the economy, have been slowing modestly. Services employment rose 1.4% from last year. Weakness in the retail category, which accounts for nearly 11% of the total workforce, has been the primary culprit for the recent decline in services-based job growth.

The most disappointing data point from this month’s report was the unexpected decline in labor force participation, which had been trending favorably in recent months. The most hotly-debated topic among economists is whether or not the 20 million prime-working-aged Americans aged 25-54 that are not in the labor force will return or remain on the sidelines. The U3 unemployment rate ticked down to 3.9%, but this was largely the result of a decline in the labor force participation rate from 60.4% to 60.3%. However, the prime-working-age male participation rate ticked up to 89.3%, the highest level since 2010.

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 has continued to moderate in recent quarters following a surge of activity from 2014 through 2017. Private construction spending rose 3.4% YoY on a seasonally-adjusted annualized basis, hovering near the lowest rate of growth of the post-recession period. On a trailing twelve-month basis, residential spending continues to be the bright-spot, rising 9.9%. Growth in non-residential spending has dipped 0.5% YoY, the slowest rate of growth since 2011. Public spending has seen a mild resurgence of late, almost breaking into positive territory on a TTM basis.

After several years of above-trend supply growth, all of the major non-residential commercial real estate have seen slowing construction activity. Developers have pulled back amid rising construction costs, tight lending markets, and slowing fundamentals in major CRE sectors caused by pockets of oversupply.

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. Tight financial regulatory conditions, a relative lack of desirable land, restrictive land-use zoning and rising construction costs have served as an impediment to supply growth. 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.

Inflation Data Ticks Higher

March inflation data was broadly in line with expectations, but the combination of higher energy prices and base-rate effects in the data have pushed most inflation metrics to the highest levels since 2016. Core CPI rose above the 2% threshold for the first time since late 2016, rising 2.12% YoY. Core PPI rose to 2.69% while Core PCE (the Fed’s “preferred” inflationary gauge) came in at 1.88% this week. Inflation expectations, as measured by the 5-Year, 5-Year Forward Inflation Expectation rate, peaked on February 2 at 2.35% and has retreated back down to 2.25%.

While overall inflation remains relatively modest, there is undoubtedly pockets of inflation emerging. Rising construction costs are a significant concern for homebuilders and developers. The price of US steel is higher by 40% since last October. Lumber prices, which were affected by the 20% tariff on Canada softwood lumber, are higher by nearly 70% since the start of 2017.Turner Construction releases a construction cost index every quarter. Construction costs rose 5.0% in 2017, the seventh consecutive year of accelerating construction cost inflation. Cost inflation has increased every year since 2009 and has exceeded 4% per year since 2013.

Bottom Line

Following their best week since 2016, REITs jumped another 2% this week as earnings continue to beat expectations. Roughly 95% of REITs raised or maintained 2018 guidance. Industrial, hotel, and retail REITs have been the winners this earnings season. Fundamentals appear to have finally bottomed in the beleaguered retail space after a brutal 2017.

Job growth has accelerated since mid-2017, reversing a multi-year slowdown attributable to tightening labor market conditions. Deregulation and corporate tax reform appear to have added another leg to the recovery. Wage growth was more moderate than expected even as the unemployment rate dipped below 4.0%. Nearly 20 million prime-working-aged Americans remain on the sidelines, a source of continued slack. While overall inflation remains moderate, pockets of inflation have emerged in recent years. Construction costs are expected to rise more than 5% in 2018, adding to the slowdown in construction activity.

This week, we published Student Housing REITs Outline Strategy to Attack Undervaluation. Student housing REITs were among the worst-performing real estate sectors in 2017 even as private market values increased markedly. Institutional demand for student housing assets has been insatiable. The sizable disconnect between public and private market real estate values, an endemic issue across many REIT sub-sectors, has forced REITs to re-evaluate their operating and capital allocation strategy. As active developers and effective capital recyclers, student housing REITs are better equipped than most sectors to exploit the NAV discount to create shareholder value.

Last week, we published Affordable Housing REITs Continue To Thrive, our first quarterly update of this earnings season. Manufactured Housing REITs delivered another strong quarter in 1Q18. Beyond the sector-leading internal growth, external growth should provide a continued tailwind in 2018. While most REIT sectors are facing slowing fundamentals as the real estate cycle matures, manufactured housing continues to exhibit remarkable consistency. The sector has been largely immune from supply-related pressures.

So far, we have updated up REIT Rankings on the Shopping Center, Hotel, Office, Healthcare, Industrial, Single Family Rental, Cell Tower, Apartment, Net Lease, Data Center, Mall, Manufactured Housing, Student Housing, and Storage sectors.

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Analyst’s 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, AMZN. 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.

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