Real Estate Weekly Review
For the 17th time out of the 21 weeks of 2019, the REIT Indexes (VNQ and IYR) finished the week higher, continuing to feel the tailwinds of the retreat in benchmark interest rates. The 10-Year yield dipped to the lowest level since late 2017 as trade worries and the sudden reversal in crude oil prices has dragged inflation expectations to the lowest level in nearly two years. For now, the domestic-focused equity sectors - including real estate - are enjoying the benefits of these 'Goldilocks' condition of low global inflation and US-led economic growth. The S&P 500 (SPY) finished lower for the third straight week while the Nasdaq (QQQ) tumbled nearly 3%. The multinational-heavy Dow Jones (NYSEARCA:DIA) finished lower for the fifth straight week, the worst such streak since 2017.
On the week, the Hoya Capital US Housing Index, an index that tracks the performance of the broader US residential housing industry, declined by 0.6% as strength in the residential REIT sector (REZ) was offset by weak performance by home improvement retailers and homebuilders (XHB and ITB). Margin concerns weighed on Home Depot (HD) and Lowe's (LOW) as well as high-end homebuilder Toll Brothers (TOL) after reporting earnings this week. As we'll analyze below, home sales data remains soft but forward-looking metrics have accelerated as mortgage rates have turned from a headwind into a tailwind in 2019. Trex (TREX), Mohawk (MHK), Zillow (Z), and Owens Corning (OC) were standouts in the housing sector this week.
This week, we published our Real Estate Earnings Recap: Housing REITs Lead Recovery. Following several years of floundering stock price performance, REITs have outperformed in 2019, boosted by receding interest rates and strengthening property-level fundamentals. Earnings results were generally better than expected with roughly 60% of REITs beating FFO estimates and less than 10% lowering full-year 2019 forecasts. Growth metrics inflected higher and generally rose throughout 2018 after bottoming at the end of 2017. The highlight of the past quarter was a reacceleration in property-level same-store NOI metrics, which jumped to 2.72% from an eight-year low of 2.16% last quarter.
The 'REIT Rejuvenation' has restored the coveted NAV premium, giving these REITs the currency to re-open the acquisition pipeline which had essentially shut down since 2017. As counterintuitive as it may be for equity analysts, elevated valuations are actually welcome news for REITs. Equity valuations play an important role in the underlying operating fundamentals of the REIT business, particularly for REITs that have historically relied on their NAV premium to fuel external growth through acquisitions. REITs, on average, are now trading at a roughly 5% NAV premium with many sectors now trading at more sizable NAV premiums, which should open accretive acquisition opportunities that didn't exist just three or six months ago.
Real Estate Economic Data
New & Existing Home Sales Misses Estimates
New and Existing Home Sales data for April was released this week and reports both came in shy of estimates. While conditions do appear to be improving in the new home sales category, existing homes have yet to feel the tailwind of receding mortgage rates. Existing sales data generally reflects selling conditions two months prior while new home sales are a bit more timely. New home sales jumped 7% over the same time last year on a SAAR-basis while existing sales dipped 4.4%.
As we've been discussing for the past several months, the forward-looking metrics in the housing market suggest a solid recovery in home sales data throughout 2019 if post-recession correlations hold. Mortgage rates are now lower by nearly 50 basis points on a year-over-year basis, a sharp reversal from the 100 basis point headwind that slowed the housing market in 2018. We continue to believe that 2018 and 2019 quite a bit like 2014 and 2015 when home sales ground to a halt following the taper-tantrum-led interest rate surge only to surge more than 15% the following year as mortgage rates reversed.
Diving deeper into the data, while inventory levels for both new and existing home sales did expand modestly in 2018, single-family housing markets remain undersupplied relative to historical averages. Newly completed homes are on the market for just 3.5 months, on average, down from 3.8 months in April 2018. Inventory of existing homes has expanded modestly from 3.8 months last year to 4.0 months in April 2018. Tight inventory levels, a result of relatively low levels of new home construction in the post-recession period, has helped support the continued rise in home values.
Tax exodus? Feeling the effects of tax reform and the cap on SALT deductions, home sales in the relatively high-tax Northeast and West Census regions continue to lag the national averages. Seemingly taxed into oblivion over the last several decades, the Northeast region now accounts for less than 5% of total new home sales while the South Census region accounts for more than 50% of new home sales. Over this time, the Northeast has generally been the most challenging region for developers to build due to restrictive zoning and a more hostile regulatory regime. Demographics are especially weak in the northeast markets where boomers outnumber millennials by nearly 20%, adding extra headwinds on home values and home sales over the next decade.
The continuing theme of the post-recession period has been the lingering underinvestment in new home construction. New home sales peaked in 2015 at an annualized rate just shy of 1.3 million and bottomed in 2011 at a rate of 300k. While existing home sales quickly recovered most of the lost ground after the housing crisis, new home sales remain far below even 1990s levels. Besides continued tight supply in the single-family markets, a secondary effect of the relative underinvestment in new single-family homes is the aging of the housing stock. The median age of a single-family home in the US is nearly 40 years old according to the American Community Survey, the oldest on record.
So far in 2019, REITs are higher by nearly 18% on a price-return basis, the best-performing S&P equity sector this year. Homebuilders are higher by more than 27%, the strongest of the eight US Housing Industry sectors. The S&P 500 and small-cap Russell 2000, meanwhile, have each climbed 13% on the year. At 2.32%, the 10-year yield has retreated by 36 basis points since the start of the year and is roughly 90 basis points below peak levels of 2018 around 3.25%. Energy prices including crude oil and gasoline have recovered this year, but have moderated in recent weeks.
This week, we published Apartment REITs: Don't Look Now, But Rents Are Surging Again. Renters enjoyed a brief reprieve from rising rents over the past two years as landlords competed to fill a record number of newly completed high-end apartment units. A “perfect storm” of factors - led by rising wages and continued robust job growth - has rejuvenated the rental markets, even as high-end multifamily supply growth remains historically elevated.
As we got later into the cycle, the variance in fundamentals between markets lessened, as there is a convergence towards supply/demand equilibrium. The West Coast markets, which were once producing double-digit annual rent growth, have cooled but continue to outperform the national average. Northeast markets, particularly New York City, as well as Houston, have bounced back into positive territory after dipping into negative rent growth last year.
Bottom Line: Another Week of REIT Outperformance
On a busy week of housing-related data, homebuilders stumbled as New and Existing Home sales Data fell short of estimates, still feeling the effects of the 2018 slowdown. Mortgage rates receded to the lowest level in 16 months, setting the stage for a strong recovery in housing data if post-recession correlations hold. Forward-looking metrics paint an optimistic picture.
Feeling the effects of tax reform and the cap on SALT deductions, home sales in the relatively high-tax Northeast and West Census regions continue to lag the national averages. REITs finished the week higher, as they have for fifteen of the eighteen weeks this year. The 10-year yield dipped to the lowest level since 2017 as trade concerns linger. Residential REITs led the gains this week as rent growth has reaccelerated to the strongest rate since 2016. Counterintuitively, elevated equity valuations are just what REITs need to revive growth.
Economic data for the week ahead include Case Shiller and FHFA home price data on Tuesday, Pending Home Sales on Thursday, and PCE inflation data on Friday. The lag on the major home price indexes are even worse than the home sales data, so we expect the indexes to continue to weaken for at least a few more months before recovering in late 2019. We'll be closely watching PCE inflation data on Friday as CPI and PPI were both cooler-than-expected last month. While pockets of price-pressure have crept up sporadically in some sectors over the past half-decade, non-sticky inflation has been largely non-existent during this time. Excluding housing cost inflation (CPI ex-Shelter), inflation has averaged just 0.8% since the start of 2013.
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Disclosure: I am/we are long HD, LOW, TOL, TGT, TREX, MHK, Z, PGR. OC, TPX, PSA, CUBE, WELL, AIV, AVB, CPT, ESS, EQR, UDR, 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.
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.
Hoya Capital Real Estate advises an ETF. Real Estate and Housing Index definitions are available at HoyaCapital.com.