Real Estate Weekly Review
Coming off their worst year since the financial crisis, the real estate sector was left for dead by many analysts and investors heading into this year on fears of the “double-whammy” of slowing economic growth and rising interest rates. How quickly sentiment can shift. The REIT ETFs (VNQ and IYR) and Homebuilder ETFs (XHB and ITB) both surged in January, each delivering one of their best monthly gains of all-time at nearly 12% and 13%, respectively. The real estate sectors added to their gains this week on a jam-packed week of economic data and earnings results.
Meanwhile, the S&P 500 (SPY) was no slouch either, jumping more than 7% on the month and notching its best January since 1989. Powered by the 100th consecutive month of job growth and an increasingly dovish Fed, the benchmark index climbed 1.6% on the week while the 10-year yield, as well as the 30-year mortgage rate, remain near ten-month lows. Reminiscent of 2016, the US seems to have reasserted itself as the primary engine of global economic growth. If so, the resultant “Goldilocks” economic conditions of solid domestic economic growth and low interest rates have historically been ideal conditions for real estate equity outperformance.
(Hoya Capital Real Estate, Performance as of 4 pm Friday)
The Hoya Capital Housing Index, an index that tracks the performance of the US housing industry, finished the week higher by roughly 3%, led by the nearly 7% surge in the homebuilding sector following generally positive results from PulteGroup (PHM), Meritage (MTH) and M.D.C. (MDC). Within the Housing Index, the brokerage and technology sector also delivered a strong week led by RE/MAX (RMAX), Zillow (Z), and Redfin (RDFN).
Residential REITs (REZ) climbed more than 2% on the week following generally strong earnings results from Equity Lifestyle (ELS), Essex (ESS), Mid-America (MAA), and Camden (CPT). As we discussed in a National Real Estate Investor article this week on the apartment REIT sector, we think that apartment REIT earnings and leasing trends will offer important insight into not only the strength of the rental markets but also of the early impacts of tax reform on homebuying behavior.
Real Estate Economic Data
(Hoya Capital Real Estate, HousingWire)
Job Growth Solid, Beating Expectations
For a record 100th consecutive month, the US economy saw a positive net addition to the nonfarm payrolls, gaining an estimated 304k jobs in January, smashing through expectations of 165k. While the government shutdown likely boosted the headline number due to federal employees seeking temporary part-time work, the recent labor market data has nonetheless been impressive across nearly all metrics. Earlier in the week, ADP reported a 213k gain in private payrolls, also beating expectations. Narrative aside, it is becoming increasingly difficult to dispute that the tax reform package of late 2017 has produced a significant positive impact on the US labor markets, even in the face of a mounting global economic slowdown. Since bottoming in late 2017 at 1.39%, the TTM growth rate of nonfarm payrolls have reaccelerated throughout 2018 and have returned to the highest level since early 2016.
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. Average hourly earnings rose 3.18% in January which was roughly in line with expectations and a slight retreat from the 3.34% rate achieved in December.
The story of the post-tax reform economic reacceleration has been a resurgence in the long-dormant goods-producing sectors. 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 at a seasonally-adjusted rate of 3.2% over last year, up with from last month's 3.1% rate, and just shy of the strongest rate of goods-producing job growth since January 1985.
Job growth in the services sector, which accounts for roughly 85% of total jobs in the US, has trended sideways since early 2017, but has seen four straight months of solid strength to end 2018. The largest single job category, retail, has been among the weakest job categories but has stabilized in 2018. The strong holiday season for retailers provides further proof that the worst of the "retail apocalypse" may indeed be over, but hiring is expected to remain slow in 2019.
The debate among Federal Reserve economists centers around the degree to which slack remains in the US labor markets. The traditional measure of unemployment ticked higher to 4.0% in January as more workers entered the labor force seeking employment, a welcome development for the US economy. We continue to believe that there is significantly more labor market slack remaining in the labor market than traditional metrics would imply, slack that could be unleashed by policy changes. The prime-age labor force participation rate remains nearly 100 basis points below the lows of the mid-2000s recession. A return to that level would imply slack of 8 million jobs, suggesting that the recovery could very well endure for another half-decade, or at very least shouldn't be hampered by the lack of labor market slack.
According to the OECD, the inactivity rate among prime-working-age males has surged from below 4% in 1960 to more than 12% today, remaining near record-high levels despite the best labor market conditions in at least a generation. There are several common explanations for the sustained decline in prime-working age male labor force participation: high incarceration rates and inability to qualify for a job after release, the higher rates of use and/or abuse of government benefits (specifically disability) programs, higher rates of opioid and drug 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.
Mixed Signals in Home Sales Data
Housing data was mixed this week as the shutdown-delayed November New Home Sales exceeded expectations and far-outpaced the private market estimates released in the prior weeks by Zillow and Redfin. Home sales data, however, is quite volatile in the winter months as relatively small changes in home sales can have outsized impacts on the seasonally-adjusted data, not to mention the impact of weather. Regardless, the housing markets will take any sign of good news amid a dismal stretch of data that began in mid-2018 as mortgage rates climbed to post-recession highs before peaking last November. Pending Home Sales data was weaker than estimates, dipping 3.5% on a TTM basis, the weakest rate of growth since late 2014.
The recent pullback in mortgage rates has started to breathe some life back into the beaten-down housing sector. The MBA Purchase Index, a useful leading indicator of new and existing home sales, earlier this month jumped to the highest level since 2010 while the MBA Refinance Index rose to the highest level since last spring. Even with the pullback in mortgage rates, however, rates are still roughly 50 basis points above the average rate between 2012 and 2018, amounting to a roughly $75 higher monthly mortgage payment on a $250,000 loan. Given the recent heightened correlation between mortgage rates and mortgage demand, investors in the single family housing markets should get used to elevated levels of interest rate sensitivity, a factor that REIT investors have become all too familiar with over the last half-decade.
Construction Spending Sees Moderating Growth
Private construction spending growth has slowed since peaking in 2015 as rising construction costs and moderating real estate fundamentals have dampened the appetite for new development. As private spending has pulled back, however, infrastructure spending has seen a sudden resurgence. Public construction spending is higher by 6.7% over the last year, the strongest rate of growth since 2009, powered by robust spending at the state and local levels on infrastructure.
Rising construction costs can have a tightening effect on supply growth in the commercial real estate market. Construction costs rose considerably throughout 2018, primarily a result of tariffs and other trade-related issues. As construction spending has moderated, construction costs have started to pull back, led lower by a sharp dip in lumber prices which had surged in the first half of 2018. The PPI index for construction materials is still higher by roughly 6% year over year while the PPI index for total construction costs remains higher by 5%.
As we discussed last week, the combination of rising land, materials, and labor costs have compressed homebuilding margins to near-zero for all but the largest national homebuilders. It’s a very different scenario than the pre-recession period as home price appreciation has been driven primarily by rising replacement costs to build rather than pure speculation and credit-fueled demand. Rising construction costs and their impact on raising home prices have had the effect of keeping new home development and supply growth far below the levels normally associated with this level of recent economic growth.
So far in 2019, REITs have gained nearly 11% while Homebuilders have surged more than 15%. The S&P 500, meanwhile, has climbed 8% on the year while the small-cap Russell 2000 has jumped 11%. At 2.69%, the 10-year yield has risen by just 1 basis point since the start of the year, more 50 basis points lower than the peak levels of last November. Energy prices including crude oil and gasoline have recovered this year after a sharp decline in late 2018 but remain sharply lower than their recent peak in November 2018.
REITs and housing-related equities have outperformed the broader US stock market over the last 25 years. The NAREIT All-Equity REIT Index has delivered an 11.4% average annual return while the Fidelity Construction & Housing Fund (FSHOX) has delivered a 11.2% annual return since 1994. The S&P 500, meanwhile, delivered a 10.7% annualized rate of return during this period.
Powered by the 100th consecutive month of job growth and an increasingly dovish Fed, the S&P 500 climbed 1.6% on the week and notched its best January in 30 years. Coming off their worst year since the financial crisis, real estate equities led the charge in January. REITs rallied nearly 12% on the month while Homebuilders surged nearly 13%.
Jobs data continues to exceed estimates, powered by a slow march higher in labor force participation. Strong wage growth has gradually pulled discouraged workers back into the workforce. Housing data was mixed this week. The shutdown-delayed November New Home Sales exceeded expectations and far-outpaced the private market estimates. Pending home sales, however, was significantly weaker than expected. Sentiment around the US housing market has gradually improved as mortgage rates remain near ten-month lows. REIT and Homebuilder earnings reports so far have generally exceeded modest expectations.
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Disclosure: I am/we are long XHB, VNQ, CPT, MAA. 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.