Real Estate Weekly Review
All good things must eventually come to an end. Following a remarkable run of performance over the past fourteen weeks, REITs (VNQ and IYR) dipped nearly 3% on the week, the worst week since diving more than 6% in late December of last year. As we cautioned last week, economic growth expectations and interest rates in the US and abroad have marched higher over the past month, threatening to upset the 'Goldilocks' economic conditions that powered REIT outperformance. The 10-Year yield climbed to four-week highs by mid-week but ended the week roughly flat. The S&P 500 (SPY) finished the week modestly lower and remains roughly 1% away from new record-highs.
Rising growth expectations have been good news for the housing market, which continues to show signs of reacceleration following a dismal end to 2018. The Hoya Capital US Housing Index, an index that tracks the performance of the entire US housing industry, retreated a more modest 0.6% as weak performance from Residential REITs was offset by strong gains in the Homebuilding (ITB) and Homebuilding Products & Materials (XHB) sectors. Beacon Roofing (BECN), CoreLogic (CLGX), Toll Brothers (TOL), Eagle Materials (EXP), Watsco (WSO), and At Home (HOME) each jumped more than 4% on the week.
Earnings season kicked off in the REIT and Housing sectors this week and will continue for the next five weeks. Industrial giant Prologis (PLD) reported another quarter of stellar results as industrial real estate demand remains insatiable, powered by supply chain densification and the "need for speed" among goods distributors. As discussed in our REIT Outlook, the REIT rejuvenation appears to be on solid footing from a fundamental perspective, helped by an improved cost of capital as most metrics appear to have bottomed in late 2017.
On a fundamental level, REITs should deliver a fairly strong year of reacceleration across many property sectors, particularly the residential and office sectors, which continue to be powered by strong job growth. Since 2013, however, fundamentals have mattered very little for REIT valuations, as the sector continues to be driven by movements in the 10-year yield, or more precisely, movements in 10-year inflation expectations. The paradigm of "rates up, REITs down" is alive and well, so an outlook for the REIT sector is very much tied to an outlook of the path of global interest rates. If Goldilocks conditions continue, expect a strong second half of the year from REITs, but if US and global growth picks up and lifts commodity prices and inflation expectations back to levels of late 2018, the REIT Rejuvenation could be short-lived. For reasons we'll analyze in the next section, GDP growth expectations have surged higher over the past month, according to the Atlanta Fed GDPNow forecast.
Real Estate Economic Data
Housing Starts Miss Estimates Despite Stronger Outlook
The resurgence of housing-related stocks in 2019 has been largely driven by the pullback in the 30-year mortgage rate, which had climbed through 2018 and reached six-year highs around 5.0% in November. At their peak last year, rates were higher by roughly 150 basis points on a year-over-year basis, the most significant climb in mortgage rates in decades. Since then, rates have pulled back by roughly 70 basis points and there are indications that buyers may be coming back from the sidelines. The MBA Purchase Index, a useful leading indicator of new and existing home sales, this week jumped to the highest level since 2010 while the MBA Refinance Index is higher by more than 40% on a quarter-over-quarter basis.
As rates have pulled back, homebuilder sentiment has improved, climbing to six-month highs in April. Homebuilder sentiment dipped late last year to the lowest level since 2015, but lower mortgage rates continued strength in the labor markets and moderating construction costs have brightened the outlook for single-family construction this year. The current sales and buyer traffic indexes improved from last month while the future sales outlook moderated slightly. The West and South regions of the United States remain the strongest regions for single-family homebuilding. Rising homebuilder sentiment data suggests that housing starts should stabilize or recover in 2019 based on past correlations between the data sets.
While the effects of lower mortgage rates are beginning to be felt in many of the forward-looking housing market data, the slower-reacting housing starts data remains soft. Housing starts missed estimates in March, dragged down by weakness across both the single-family and multifamily categories. At this point, weakness in housing starts data is likely still reflecting soft conditions in late 2018, considering the lag between project conception and ground-breaking. Total housing starts dipped into negative territory on a trailing-twelve-month basis for the first time since 2011.
By nearly every metric, single-family housing markets remain significantly undersupplied. Household formations outpaced new housing starts by more than 100k in 2018 as the vacancy rate for both owner-occupied and renter-occupied homes reached multi-decade lows in the fourth quarter. The United States has been under-building homes since the early 1990s, and that trend of underbuilding has intensified dramatically since the housing bubble burst in 2008. A shortage primarily rooted in sub-optimal public policy at the local, regional, and national levels, the US is building homes at a rate that is less than 50% of the post-1960 average after adjusting for population growth.
Retail Sales Growth Has Slowed After Strong 2018
After reaching the fastest rate of growth since 2012 in the middle of last year, retail sales growth has generally moderated over the past several months, but data was stronger than expected in March. On a trailing-twelve-month basis, total retail sales slowed to 4.2%, retreating from the 5.5% peak rate achieved in August as tough comparables will weigh on the data through the end of the summer. Non-store (e-commerce) retail sales have moderated to sub-10%-growth levels for the first time since 2016. Even with the weak end to 2018, the brick-and-mortar retail category grew at the strongest full-year rate since 2015.
Particularly relevant to the housing markets are the hardline retail categories which include building and home improvement as well as furniture sales. These two categories accelerated from early 2017 through mid-2018 but have moderated considerably over since last summer, corresponding to the broader slowdown in the US single-family housing markets. Indicated by strong price performance from the Home Furnishings and Home Improvement sectors this year, however, optimism is high that sales in these sectors will recover alongside a potential recovery in housing data.
While hardline and food retailers tend to be somewhat immune from e-commerce related disruption, softline and specialty retail categories are generally more at-risk. During the so-called "retail apocalypse" of 2016-2017, these categories were particularly weak but recovered nicely in 2018. Growth has generally moderated so far in 2019, particularly in the primarily mall-based categories including department stores, sporting goods/hobby, and electronics. Clothing continues to see solid but moderating growth.
Last week, we published Mall REITs: Catch A Falling Knife. The bifurcation between top-tier and lower-tier mall REITs continues to widen. Store closings remain elevated in low-productivity properties and the outlook for these malls remains grim. For high-productivity malls, however, the metrics are stronger than the stock performance suggests. Occupancy remains around 95% and leasing spreads averaged 10% in 2018 as the long-term outlook remains solid.
The rate of e-commerce market share growth is particularly relevant to the retail REIT sectors, as well as the flip-side of the coin, the logistics and distribution-focused industrial REIT sectors which stand to benefit from growth in e-commerce. E-commerce remains a relatively small slice of total retail sales at roughly 10% but represents nearly 20% of at-risk categories which exclude automotive, gas, and food. The relevant statistic to watch, in our view, is the rate of e-commerce market share gains. From 2013 to 2016, e-commerce market share gains were accelerating, corresponding with calls for the retail apocalypse, but have moderated over the last two years as brick-and-mortar retailers found relatively more success in attracting customers through the doors.
So far in 2019, REITs remain higher by nearly 15% on a price-return basis while Homebuilders are higher by nearly 27%, bouncing back after their worst year since 2008 for each sector. The S&P 500 and small-cap Russell 2000, meanwhile, have each climbed 16% on the year. At 2.56%, the 10-year yield has retreated by 13 basis points since the start of the year and is roughly 70 basis points below peak levels of 2018 around 3.25%. Energy prices including crude oil and gasoline have recovered strongly this year after sharp decline in late 2018.
The week, we published Healthcare REITs: Stuck in Rehab. Following three straight years of underperformance, healthcare REITs showed signs of life in 2018. The early tremors of the long-awaited demand boom are finally beginning to appear. The investment thesis related to the "aging population" has been no secret. The healthcare real estate industry - especially senior housing -continues to battle an "addiction" to new supply growth. Supply pressures are expected to linger throughout 2019 as expense growth continues to outpace revenues. These REITs have been reluctant to call a bottom to fundamentals.
Last week, we published Industrial REITs: Not Tired of Winning. Since the start of 2016, no major real estate sector has outmatched the performance of industrial REITs, outperforming the broader REIT index by a cumulative 45% during this time. Rents grew another 8% in 2018 according to Prologis (PLD) as demand once again outpaced supply, the ninth consecutive year of a positive demand imbalance.
We also published Data Center REITs: Big-Tech Looms Over Cloud Boom. Data center leasing smashed records in 2018, jumping more than 30% for data center REITs, powered by a nearly 50% surge in capex spending from hyperscale providers. A concern for investors, the competitive landscape is quickly shifting as these "big tech" hyperscale providers are increasingly dictating the terms of the still-symbiotic relationship between REITs and their tenants.
Bottom Line: Worst Week for REITs This Year
After climbing for a remarkable thirteen out of the past fourteen weeks, REITs stumbled this week, dipping nearly 3% despite an otherwise solid start to earnings season. Economic growth expectations - and interest rates - in the US and abroad have marched higher over the past month, threatening to upset the 'Goldilocks' economic conditions that powered REIT outperformance.
Homebuilders rallied this week as the single-family housing market outlook continues to strengthen following a dismal 2018. Homebuilder sentiment climbed to six-month highs. Accelerating forward-looking housing market metrics, however, have not yet translated into starts and permitting data. Housing starts declined over the past twelve months for the first time in eight years.
Next week will be jam-packed with economic data, beginning with Existing Home Sales on Monday. New Home Sales and the FHFA House Price Index will be released on Tuesday and Q1 GDP will come out on Friday.
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Disclosure: I am/we are long BECN, CLGX, TOL, EXP, WSO, HOME, NVR, LEN, OC, PPG. 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: It is not possible to invest directly in an index. Index performance cited in this commentary does not reflect the performance of any fund or other account managed or serviced by Hoya Capital Real Estate. All commentary published by Hoya Capital Real Estate is available free of charge and is for informational purposes only and is not intended as investment advice. Data quoted represents past performance, which is no guarantee of future results. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy.
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