Real Estate Weekly Outlook
On a consequential "jobs week" ahead of the all-important September Fed meeting, US equity markets climbed for the second straight week. Aside from a miss on the BLS's headline nonfarm payrolls figure, employment data was actually quite solid, but likely not strong enough to derail expectations of easing monetary policy into the end of the year. Signs of thawing trade tensions between the US and China sparked optimism that a trade deal could potentially be reached before the current slowdown in the manufacturing and goods-producing sectors begins to bleed into the broader US economy.
Following a nearly 3% in the prior week, the S&P 500 (SPY) climbed nearly 2% this past week while the Nasdaq (QQQ) ended higher by 2.2%. REIT investors continue to party like it's 2016 as the broad-based REIT ETF (VNQ) gained another 1.3% on the week, finally clawing its way to a new record high, surpassing its prior 2016 highs. REITs are now higher by more than 25% in 2019 as the ideal "Goldilocks" macroeconomic conditions of low inflation and moderate, consumer-led growth continue to provide a favorable backdrop for outperformance from the domestic-focused commercial and residential real estate sectors.
Perhaps the best evidence that the US economy is in better shape than the prevailing narrative suggests, Hoya Capital US Housing Index, which tracks the GDP-weighted performance of the US Housing Industry, finished the week higher by another 1.3%, setting new all-time record highs. No doubt helped by the 30-year fixed mortgage rate which fell to within 20 basis points of all-time record lows, this past week's gains were broad-based, led by the home furnishings, home building products, and home improvement sectors. The recently unstoppable RH (RH) continued its recent surge ahead of next week's earnings. Property insurance firms including Travelers (TRV) as well as manufactured housing REITs (Sun Communities (SUI) and Equity LifeStyle Properties (ELS)) also breathed a sigh of relief after Hurricane Dorian spared the US's East Coast from significant damage.
Last week, we published our Earnings Recap, The REIT Revival Is Real. The domestic-focused, defensively-oriented REIT sector has been a standout so far in 2019 following several years of middling performance. 2Q19 earnings results confirmed the positive momentum. Earnings season was better than expected. 60% beat FFO estimates, which was roughly in line with historical averages. An impressive 50% of REITs raised guidance, however, which was well above historical averages. Property-level metrics have been accelerating as well, helped by a slowdown in supply growth and resilient demand across most sectors. Same-store NOI growth jumped to 2.64% from the downwardly revised 2.45% last quarter.
Real Estate Economic Data
Mixed, But Solid, Employment Data in August
Following an in-line month for jobs growth in July, the BLS reported that total nonfarm payrolls rose 130k in August, below consensus estimates of roughly 160k. In the same report, the Household survey showed an impressive 570k jump in employment, the best month for that data series since February 2018. Earlier in the week, the ADP reported a 195k rise in private payrolls, ahead of estimates of 150k. Overall, the pace of job creation has slowed following a mid-cycle reacceleration in 2018, as BLS job growth has averaged 158k per month so far in 2019, down from 223k in 2018, a slowdown that, in our view, can be partially ascribed to overly restrictive monetary policy guidance in late 2018 and into early 2019 as well as trade-related uncertainty.
While job growth has moderated since the reacceleration in 2018, growth in average hourly earnings has continued to accelerate since early 2018, rising 3.2% in August. Real wage growth, as measured by real average hourly earnings or real disposable personal income per capita, remains near cycle-highs. Contrary to the popular political narrative, lower-income wage brackets have actually seen the strongest wage growth over the past two years. Core PCE inflation data released last week showed that inflation rose just 1.6% in May, as inflationary pressures remain muted after a brief inflation scare in 2018. Real wage growth grew 1.5% in August, still near the strongest rate of real wage growth since the pre-recession period. At 1.8%, productivity (Real Output Per Hour of All Persons) last year grew at the fastest rate since 2009. Along with a growing labor force, productivity growth is the key component to real economic growth on a per-capita basis.
Despite the growing drumbeat of recession warnings from the financial and mainstream media, the US consumer has shown signs of resilience in the face of slowing global growth. Consumer spending, which represents roughly two-thirds of US GDP, has shown early signs of reacceleration, following a slowdown in the second half of 2018. Personal income and spending data released last week was generally better than expected with personal incomes rising 4.6% and personal spending growing 4.2%. While consumers continue to see healthy wage growth, they are increasingly on edge, as both the Michigan Consumer Sentiment Index and Conference Board Consumer Confidence Index ticked lower in August.
The story of the last year's economic reacceleration was a resurgence in the long-dormant goods-producing sectors. Manufacturing jobs, which had entered a mild recession in 2016, saw significant growth in 2018 but have slowed over the past two quarters. Job growth in the goods-producing sectors grew at a seasonally-adjusted rate of 1.8%, slowing from the high of 3.3% growth recorded in mid-2018, which was the strongest rate of goods-producing job growth since January 1985. Construction added 14,000 jobs last month while manufacturing added 3,000. The mining and logging industry lost a combined 5,000 jobs in August. Goods-producing sectors contributed 12k jobs to the 130k total jobs added in August.
Job growth in the services sector, which accounts for roughly 85% of total jobs in the US, has trended sideways since early 2017, but had seen several solid months of growth since late 2018. Continued weakness in the retail category, which lost another 11,100 jobs last month, has reversed the recent positive momentum as analysts are fearing that the sector is showing signs of a "double-dip" following a brief recovery after the so-called "retail apocalypse" of 2016-2017. Hiring in the professional services and healthcare categories has seen solid and accelerating growth since late 2016, which added 37,000 and 24,000 jobs last month, respectively. Financial activity employment rose by 15k in August with half the gains occurring among insurance carriers. Goods-producing sectors contributed 84k jobs to the 130k total jobs added in August.
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.
The traditional measure of unemployment, the U3 unemployment rate, remained steady at 3.7% while the U6 rate ticked up to 7.2% from 7.0%. Household data showed an impressive 590k rise in the civilian labor force, taking the labor force participation rate up to 63.2%, a post-crisis high. As we have discussed for the last three years, we continue to believe that there is significantly more labor market slack remaining in the labor market than traditional metrics would imply, slack that has begun to be unleashed by continued wage growth and policy changes that reduce disincentives to employment. While the prime-age labor force participation rate matched the highest level since 2009 in August, it remains nearly 100 basis points below the lows of the mid-2000s recession, 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.
Construction Spending Sees Moderating Growth
Earlier in the week, the US Census Bureau reported that Construction Spending for July 2019 was roughly in line with consensus estimates, continuing a path of moderating growth since peaking in early 2016. For the first time since March 2012, total construction spending contracted on a trailing twelve-month basis, dipping 0.6%. Residential construction spending has declined by 6.0% over the last twelve months while non-residential spending has risen by 2.4%. Public construction spending has been the relative bright spot with spending by federal, state, and local governments rising by 4.5% over the past year.
Interestingly, residential construction hiring has been far stronger than the construction spending data would suggest and actually showed a sharp acceleration in the final months of 2018, a divergence that is difficult to square away. Job growth in the residential construction sector was strong in August, posting an increase of 7k jobs which was the best rate of growth since January. Combined with lower construction costs and lower interest rates, we anticipate a reacceleration in residential construction spending in the second half of this year from a combination of repair and remodeling spending and an uptick in single-family home construction, but note that tight construction labor markets will continue to be a headwind for the sector.
Rising construction costs have had 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. As we discussed in our recent homebuilding report, the combination of rising land, materials, and labor costs has compressed homebuilding margins to near-zero for all but the largest national homebuilders, but the outlook has brightened in 2019 as cost pressure has moderated.
Even before adjusting for construction cost inflation, total construction spending remains well below the peak of the prior cycle. Residential construction spending peaked in 2016 at a rate that was 20% below the prior peak in early 2005, but after adjusting for the considerable construction cost inflation during this time, spending was more than 50% below the bubble peak. Private nonresidential spending, which did not see quite the same boom in construction activity to the same extent as the residential sector in the early 2000s, is now 10% above the previous peak in early 2018, but roughly 15% lower on an inflation-adjusted basis.
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.
2019 Performance Recap
With gains of more than 25% so far this year, the broad-based REIT ETFs (VNQ and IYR) continue to outperform the S&P 500, which has climbed roughly 19%. Not all REITs are seeing the windfall, however, exhibited by the 60% performance gap between the best- and worst-performing REIT sectors. The US Housing sector has climbed 25% this year led by the 42% surge in Homebuilders (ITB). At 1.55%, the 10-year yield has retreated by 114 basis points since the start of the year and is roughly 170 basis points below peak levels of 2018 around 3.25%.
This week, we published Net Lease REITs: The Right Kind of Retail. Despite mounting concerns of a “Retail Apocalypse 2.0” given the unexpected surge in store closings this year, net lease REITs have bucked the negative retail trends and continue to outperform. While nearly two-thirds of a net lease REIT’s revenue comes from retail-based tenants, it’s primarily the “right kind” of retail. Restaurants, convenience stores, fitness, and home improvement are top tenants.
Second-quarter earnings results were generally in line with expectations with seven of the ten net lease REITs maintaining full-year AFFO guidance. The "Power 3" net lease REITs (Realty Income (O), National Retail (NNN), STORE Capital (STOR)) are expecting AFFO to grow an average of 4.4% this year and are expected to account for more than 80% of the total net acquisition activity this year.
Week Ahead: JOLTS, Inflation & Retail Sales
The economic calendar this coming week is highlighted by JOLTs, inflation, and retail sales data. On Tuesday, we get a look at July's Job Openings and Labor Turnover Survey. For most of the past two years, the number of job openings has outpaced the total number of unemployed Americans seeking work by at least one million. On Wednesday, we get a look at PPI data, while on Thursday, we'll see CPI data for August. Inflation has been quietly running warmer-than-expected over the past three months, boosted by the continued and persistent rise in housing costs (CPI: Shelter). Finally, we'll take a look at retail sales data, which has actually held-up rather well this summer despite this year's reacceleration in store closings and continued weakness in retail hiring.
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Disclosure: I am/we are long VNQ, STOR, LEG, BBBY, PPG, RH, TRV, HST, MLHR, W, MIDD, WHR. 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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