Real Estate Weekly Review
All good things must eventually come to an end. The REIT ETFs (VNQ and IYR) failed to extend their rally to a record-eight straight week, dipping by 1.4% on the week. The tech-focused Nasdaq (QQQ) gained for the tenth straight week, however, capping off one of the best two month starts for US equity markets of all time. Solid macroeconomic data and rising global bond yields pushed the 10-year yield to its highest level since mid-January, pressuring the yield-sensitive segments of the equity markets.
Meanwhile, the S&P 500 (SPY) climbed 0.5% on the week, gaining for the ninth week out of the past ten. The backlog of long-delayed economic data has painted a mixed picture on the US economy, but strong Q4 GDP data helped to settle some uncertainty, indicating that the late 2018 slowdown appears to have been mild, at worst. Concurrent and forward-looking metrics have shown notable improvement through the first two months of 2019, particularly in the single-family housing markets. Investors remain optimistic that the US and China will soon come to a trade truce, relieving one of the most pressing headwinds on the global economy.
After surging through the first eight weeks of 2019, the housing sector took a leg lower this week, dragged down by weak performance from the homebuilding (XHB and ITB) sector, which dipped nearly 6% on the week. As we'll discuss below, the long-delayed December housing starts data was weaker than expected and earnings results from Toll Brothers (TOL) were mixed as new home orders dipped 24% from the first quarter of last year. The Home Furnishing sector was the leader of the Hoya Capital Housing Index this week, climbing more than 2%, led by a jump in Wayfair (W), Restoration Hardware (RH), and Williams-Sonoma (WSM).
Apart from a handful of REITs to report next week, real estate earnings season wrapped up this week, highlighted by strong results from Public Storage (PSA), helping to push the self-storage sector to a REIT-sector-leading 3.7% gain this week. Other notable results this week included brokerage firm Realogy Holdings (RLGY), which dipped more than 25% on the week after weaker-than-expected results, which the company attributed to a turbulent housing market at the end of 2018.
2018 turned out to be a tough year for residential housing. Industry transaction volume was basically flat compared to plus 6% in 2017 according to NAR. Most of the challenge in the 2018 housing market showed up in the last four months of the year. Industry transaction volume was down 7% in September, down 4% in Q4, and ended the year with an especially down month minus 10% in December. The topics we've been talking about throughout 2018; low inventory levels, affordability challenges, and higher mortgage rates combined to drive the big transaction volume declines in late 2018.
Generally, REIT and housing-related earnings have been in-line or slightly ahead of expectations. For REITs, continuing a trend of the past two years, forward guidance appears to be very conservative. This week in a report on National Real Estate Investor, we noted that while the broader sector will continue to be dictated by macroeconomic conditions, there will continue to be significant differences in intra-sector trends. Through two months of this year, for example, there is a 13% variance between the best and worst performing REIT sectors, hotels and mall REITs, respectively.
US Economic Expansion Continues
Delivering better-than-expected growth in the fourth quarter of 2018, the US economy finished its strongest year since 2005. Powered by robust consumer spending and surging nonresidential fixed investment, GDP rose by a 2.6% annualized rate over the prior quarter and by 3.1% over the same period last year. After a disappointing 2016 that saw economic momentum slow with GDP rising just 1.6%, tax reform and deregulation appear to have contributed to a consumer-led economic reacceleration. Consensus expectations call for slowing growth in early 2019, however, with the Fed's GDPNow tracker forecasting just 0.3% growth in the first quarter.
Recent economic growth has been even more impressive considering the negligible impact of real estate development. Growth in residential fixed investment and business investment in structures was actually a drag in the fourth quarter, subtracting a combined 0.3% from the GDP growth figure. For context, these two categories boosted GDP by 1.3% at the peak in 2002 and dragged down GDP growth by 1.1% at the bottom in 2008. Residential construction contribution to GDP growth receded for the fourth straight quarter while nonresidential investment in structures turned negative for the second straight quarter. The combined negative contribution of real estate building to GDP growth was the second worst since 2010 when these two categories combined to subtract nearly 1% from GDP.
Looking at this data through another lens, we see that real estate construction’s share of GDP remains well below the pre-recession period. The surge in residential investment fueled the housing bubble in the mid-2000s and was responsible for 6.6% of GDP in 2005. Residential fixed investment now makes up just 3.8% of GDP while business nonresidential investment in structures makes up 3.1% of GDP. This period of moderate supply growth across the residential and nonresidential sectors continues to support valuations of housing and commercial real estate assets.
Housing Starts Disappoints in December
The historical trends of under-investment in residential housing do not appear to be getting much better anytime soon. The long-delayed housing starts data for the month of December was released this week, and it wasn't pretty. Total housing starts ticked lower to 3.5% on a trailing twelve-month basis, slowing from the 4.0% rate last month. Multifamily starts, however, jumped to the strongest rate since 2016 at 5.0%, recovering following a slowdown in development activity amid fears of oversupply in high-end apartment markets. Strong rental demand has supported apartment fundamentals over the last two years amid elevated supply growth. Single family starts continue to be weak, however, slowing to just 2.8% TTM growth, the slowest rate of growth since 2012.
The picture isn't too much brighter when viewed through the lens of housing permits, a forward indicator of future starts. While permitting data beat expectations in December, the overall trends remain weak. Total permits rose by just 2.3% in 2018, the slowest rate of growth since 2009. The multifamily sector, the bright-spot of the starts data, has not shown the same strength in the permitting data.
Zooming out, we see the longer-term trends in housing starts since the early 1970s. A theme that we continue to discuss, population growth and household formations have significantly outpaced new home construction since the mid-1990s. Structural impediments to supply growth, including restrictive zoning and poor public policy, have intensified over this time. In some cases, the effects of these policies have been addressed by even worse public policy, including Oregon's passage of the first-ever statewide rent control law just this week. While politically popular, a substantial body of evidence indicates that rent control measures tend to lead to long-term negative outcomes, including decreased local residential fixed investment and worsening affordability.
Homeownership Rate & House Prices
This week, the US Census released the quarterly Residential Vacancy and Homeownership report, which showed that the homeownership rate climbed to the highest level in four years. Leading the gradual recovery has been a climb in the homeownership rates in the younger segments, particularly the <35 and 35-44 categories, which were hit the hardest from the housing recession. At 64.2%, the overall homeownership rate remains well below peak levels of 69.2% in 2004. Given the abnormally large 4-year cohort of 25-29 year-olds, we think that the homeownership rate will see continued gradual increases over the next five years as this "mini-generation" enters prime first-time homebuying age.
Homeownership's gain is not coming at the expense of the rental market, however, but rather the result of rising total household formations. Total household formations topped 1.36 million in 2018, climbing 1.1% over the prior year, the strongest rate of growth since 2015. By comparison, housing starts totaled 1.25 million, leading to further tightening in the already undersupplied housing markets. The rental vacancy rate retreated to the lowest level in 34 years at 6.6% while the homeowner vacancy rate retreated to just 1.5%, the matching the lowest level in nearly 20 years.
To bring it all together, the effects of these trends has been a persistent rise in overall housing costs, manifesting in rising rents and higher home values. Housing inflation has outpaced the broader inflation rate on a year-over-year basis in 90% of months since 1995 and does not show signs of receding anytime soon. Housing accounts for a third of average consumer spending and the "wallet share" of housing and housing-related services have increased significantly over the last decade. Given the recent slowdown in housing starts, combined with favorable demographics for household formation growth, it appears that that rising housing costs will continue to be a theme well into the next decade.
So far in 2019, REITs have climbed by 12% while Homebuilders have climbed roughly 10%, bouncing back after their worst year since 2008 for each sector. The S&P 500, meanwhile, has gained 12% on the year while the small-cap Russell 2000 has jumped 18%. At 2.76%, the 10-year yield has climbed by 3 basis points since the start of the year, but is still roughly 50 basis points lower than peak levels of last November. Energy prices including crude oil and gasoline have recovered this year after sharp declines in late 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 a 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.
REITs failed to extend their impressive 7-week rally, ending the month of February flat after surging more than 13% in January. The Nasdaq gained for a tenth straight week. Solid macroeconomic data and rising global bond yields pushed the 10-year yield to its highest level since mid-January, pressuring the yield-sensitive segments of the equity markets.
Homebuilders slide by nearly 6% on the week on a jam-packed week of housing data. Long-delayed housing starts data for December was weaker than expected but permit data was solid. Household formations remain strong as the homeownership rate climbed to the highest rate in four years. The rental vacancy rate also fell to the lowest level in 34 years.
The US economy grew faster than expected in the fourth quarter despite minimal contribution from real estate development. GDP grew at the fastest full-year rate since 2005. Its another busy week of economic data next week, highlighted by December new home sales on Tuesday, and payrolls and January housing starts/permits data on Friday.
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Disclosure: I am/we are long VNQ, XHB, PSA. 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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