Real Estate Weekly Review
Following the worst May for the major equity indexes since the recession, the first two weeks of June have been far more gratifying. After surging more than 4% last week, the S&P 500 (SPY) and Nasdaq (QQQ) added to their gains this week and record highs are again within striking distance. Investors anticipate easing monetary policy, bolstering a "Goldilocks" backdrop of solid but uninspiring economic growth with muted inflationary pressure and low interest rates.
An ideal macroeconomic backdrop for the yield-sensitive equity sectors, REITs (VNQ and IYR) continue to outperform, adding another 0.8% this week and pushing YTD gains back above 20%. Economic data was generally better-than-expected this week, potentially casting some doubt on the urgency of rate cuts, but benign inflation suggests a limited risk of overheating if the Fed does indeed cut rates. Two rate cuts are priced into market expectations, the first of which occurring at next month's July meeting. The 10-year yield ended the week essentially unchanged near the lowest levels since September 2017.
On the week, the Hoya Capital US Housing Index, an index that tracks the performance of the broader US housing industry, jumped another 1.3% and closed just shy of a new record high. The Home Improvement Retailer and Home Furnishings sectors surged more than 3.5% following a resolution of the Mexico/US tariff threat and on strong earnings from Restoration Hardware (RH). Homebuilders (ITB) climbed another 1% on the week and are higher by 30% YTD as low mortgage rates have been a godsend for US housing markets, reigniting the sputtering sector after a significant slowdown in 2018.
Real Estate Economic Data
Mortgage Demand Surges on Lower Mortgage Rates
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 120 basis points and there are indications that buyers may be coming back from the sidelines. Weekly applications for mortgage loans jumped by 26% last week, led by a 47% jump in refinancing mortgages. The MBA Purchase Index, a useful leading indicator of new and existing home sales, continues to show strong growth, up by 10% over the past six months.
As we discussed in our recent report, Homebuilders: It's A Buyers Market, homebuyers appear to be sensing a short window of opportunity where home price appreciation has moderated while affordability has greatly improved given the sharp decline in mortgage rates. For homebuilders, the winds have shifted rather dramatically over the last five months as the strongest headwinds of 2018 - higher materials prices and higher mortgage rates - have turned into tailwinds this year. We expect these forward-looking metrics to begin to show up in the slower-reacting home sales and construction data within the next month or two, perhaps as soon as next week's Housing Starts & Permits data.
Inflation Remains Tame But Rents Growth Heats Up
Inflation was - and remains - the key threat to potentially ending the nearly decade-long economic recovery. Rising oil prices, along with rising costs from tariffs and trade disputes, had put upward pressure on inflation throughout 2018, pushing both the 10-year yield and 30-year mortgage rates to post-recession highs. The plunge in oil prices in late 2018, along with moderating global growth, has quelled much or all of that inflationary pressure. All three inflation indexes - Core CPI, PPI, and PCE - were cooler-than-expected in May and have continued to trend down in recent months. Moderating inflation should give the Fed more confidence that an interest rate cut has limited risk of resulting in near-term overheating.
Housing (CPI:Shelter) accounts for more than a third of the total CPI weight (42% including housing-related services), and since 2013, housing inflation has been significantly above the overall inflation rate. From 2015 through late 2016, housing inflation was one of the only components keeping Core CPI out of deflationary territory, and since 2013, core inflation excluding housing has averaged less than 1%. Housing inflation has reaccelerated over the last several months after moderating slightly in 2018. Consistent with recent private-market rent growth data showing a reacceleration in rents since late 2018, at 3.7%, Primary Rents ticked back slightly after reaching are rising at the fastest rate since mid-2017 last month.
The importance of housing costs on the overall price index cannot be overstated. Since 1995, shelter inflation has outpaced the broader rate of inflation by more than 1% per year, fueled by a persistent supply shortage in the most in-demand US housing markets. Over the last three decades, structural impediments to supply growth, aggravated by the dramatic dislocations during the housing crisis, have dramatically slowed the rate of housing starts per capita. On a rolling 10-year average, residential fixed investment as a share of GDP is the lowest since the end of WW2. The implications of this housing shortage, we believe, will be a continued persistence of "real" housing cost inflation and a long runway for growth in residential housing construction in order to equalize the supply/demand imbalance.
As we discussed last week, amid this housing shortage, demand for housing has accelerated over the past three years driven by robust job growth and rising real wage growth. 2018 was the strongest year for household formations (both renting and owning) since 1985 at nearly 2%. Below-trend household formation growth in the post-recession period suggests that there may be a substantial slack of "deferred" households - notably from multi-generational and "roommate-by-necessity" households - that could be unlocked over the next several years. Demographics remain extremely favorable into the 2020s for household formations, particularly in the single-family category, as the largest 4-year mini-generation in the United States is currently aged between 26 and 30.
Retail Sales Solid in May, But Growth Still Slowing
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 generally better than expected in May. On a trailing twelve-month basis, total retail sales have climbed 4.1% while brick-and-mortar sales have climbed 3.1% over the last year. Last month's gains were powered by gains in the e-commerce, restaurants, and motor vehicles categories.
This week, we published Retail REITs: Fears of Retail Apocalypse 2.0. Store closings have unexpectedly surged in 2019. For retailers, the more significant issue over the last two years has not been on the demand-side, but rather on the expense-side. Before even considering the margin hit from tariffs and excess inventory, labor costs have risen considerably over the last two years as eighteen states raised their minimum wage in 2018 and many cities (largely in already high-cost markets) have raised minimum wages over the last two years, oftentimes far above market rate, which has begun to result in retail job cuts and store closures. Hourly earnings surged to 5% in early 2019, outpacing the roughly 3% growth in retail sales, while retail has been negative on a year-over-year basis for all of 2019.
Despite the strongest year for brick-and-mortar retail sales since 2012, retail REIT metrics have generally softened over the last several quarters. While 1Q19 earnings were marginally better than expected on relatively low expectations, full-year guidance may be difficult to achieve if recent retail trends continue. Open-air shopping center REITs have been the relative outperformers within the retail sector since 2017. The bifurcation between top-tier and lower-tier retail REITs continues to widen as retailers focus investments into the highest productivity locations.
Nearly halfway through 2019, REITs are now higher by more than 20% on a price-return basis and 22% on a total-return basis. Homebuilders are higher by more than 30%, bouncing back after their worst year since 2008 for each sector. The S&P 500 has gained just shy of 16% while the small-cap Russell 2000 has climbed 13% on the year. At 2.09%, the 10-year yield has retreated by nearly 60 basis points since the start of the year and is roughly 120 basis points below peak levels of 2018 around 3.25%. Energy prices including crude oil and gasoline, which jumped through the first five months of 2018, have given back roughly half of their YTD gains over the last month.
This week, we published 5 High-Yield Real Estate ETFs For Income Investors. In a world of perpetually low interest rates, investors have piled into yield-oriented equities and real estate sectors to quench their vivacious appetite for yield. High-yield real estate ETFs are especially popular, which offer juicy dividend yields of 6-10% compared to their broad-based real estate ETF counterparts yielding below 4%. We analyzed the most popular high-yield REIT ETFs.
Bottom Line: Big Week of Housing Data Ahead
Adding to strong gains so far in 2019, REITs and Homebuilders delivered another solid week of outperformance, pushing YTD gains above 20% and 30%, respectively. The major equity indexes finished modestly higher as investors await the much-anticipated Federal Reserve meeting next week. Two rate cuts by the end of 2019 are priced into expectations.
Economic data was generally better than expected this week, potentially casting some doubt on the urgency of rate cuts. Retail sales were above estimates, but growth has slowed this year. Inflation remains muted as CPI and PPI data were generally cooler than expected. Excluding the steep and continued rise in housing costs, inflation has averaged less than 1% over the last half-decade. Low mortgage rates have been a godsend for US housing markets. Mortgage applications surged this week as forward-looking housing data continues to suggest a housing market rejuvenation in 2019.
Homebuilder sentiment data on Monday kicks off a busy two weeks of housing data. Consensus estimates see a continued climb in Homebuilder sentiment to 67, up from 66 last month. Housing permits and starts data is released on Tuesday. Both housing construction metrics have been soft since mid-2018 and has yet to show signs of upward inflection from improving housing market conditions, but we expect upward surprises over the next few months based on forward-looking metrics. On Wednesday, the Federal Reserve is expected to announce to keep rates steady at 2.5%, but signal that one or more cuts could be expected through the end of 2019 if economic data continues to soften. Wrapping up the busy week, existing home sales data is released on Friday.
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Disclosure: I am/we are long RH, AAN, WY, LPX, WSM, RDFN, RCH, WHR, RF, HD. 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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