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Q1 2018 Real Estate Outlook: Focus on Today’s Real Estate Fundamentals, Not Market Fears

Despite strong job growth, high occupancy rates, and rent growth outpacing price growth, the public real estate markets are trading at significant discounts to net asset value (NAV). Fear appears to be the biggest driver of this market dislocation. Investors are worried about rising interest rates, pricing pressures, and a mature real estate cycle.

The impact of fear is nothing new. While private real estate markets are typically insulated from rate hike hysteria, public REITs have generally been sensitive to short-term spikes in interest rates. The REIT sector historically trades at roughly five percent above NAV, but bottomed at nearly 11 percent below NAV in February, coinciding with Treasury yields spiking from 2.60 percent in mid-January to 2.95 percent just over a month later.

 

Economy continues to show signs of promise

Long term, real estate tends to follow economic fundamentals more than interest rate movements, and these fundamentals are broadly in the “sweet spot.” The United States added 313,000 jobs in February, the most since July 2016, with impressive gains across industries. Average hourly earnings also recently climbed to their highest level since the summer of 2009. And while the U.S. economy is seeing moderating gross domestic product (GDP) growth, many parts of Europe and Asia are driving robust global growth, in some cases running six percent or higher.

Market distortion offers investment opportunities

This difference between fear and fundamentals may offer investment opportunities in the public markets. Demand has remained high with suppressed supply in industrial real estate, as companies continue to have trouble finding suitable locations for last-mile facilities. Current demand is being driven by the development of customized corporate logistics centers, which may bring lower risk to investors than acquisition-driven demand.

Industrial also experienced net operating income (NOI) growth of nearly five percent over the last four quarters. Cap rates declined slightly, but price growth was slower than the increase in NOI. This is a favorable outcome that suggests industrial real estate valuations are not getting ahead of fundamentals. This is important as the Federal Reserve’s latest Monetary Policy report in late February noted valuation pressures on commercial real estate.

At the end of 2017, all equity REITs saw their highest occupancy rates in over two decades.

However, real estate’s pricing appears fairly valued when relying on the fundamentals. Cap rates across sectors remain low compared to the previous cycle, and the cap rate spreads to Treasury yields have ample room to compress as interest rates move higher. This dynamic suggests relatively little pressure on property prices as interest rates rise.

There is still a supply-demand imbalance in apartments and industrial, and occupancy rates are trending higher across all sectors. At the end of 2017, all equity REITs saw their highest occupancy rates in over two decades.

Supply remains manageable in a mature cycle

Real estate is moving into the “later innings” of its current cycle, but encouraging economic and real estate fundamentals may extend growth for longer than previous cycles. Core inflation, while showing signs of life, is still relatively muted, supply concerns are still low for most sectors, and low unemployment continues to buoy high demand.

Fears over excess supply may be overblown as many developers are still running into high costs associated with labor and debt financing. More expensive costs tend to produce more expensive builds, which would accentuate the supply problems already occurring in sectors like multifamily.

[Related:Hear portfolio manager John Snowden’s audio summary of this Commentary]

Supply may also be saddled by President Donald Trump’s proposed trade policies. The markets have ebbed and flowed with the administration’s threats to renegotiate the North American Free Trade Agreement (NAFTA) with Canada and Mexico, as well as new tariffs on steel and aluminum.

The list of countries impacted by these tariffs is still fluid, but key trade partners like Canada, Mexico, and Australia have already been excluded. Keeping these tariffs in place may dampen construction reliant on these materials, and industrial supply chains could be affected by the talks of a trade war. However, this bluster may also present pockets of value, especially in the industrial space, if public markets react with fear to a trade war unlikely to be carried out by a pro-trade, Republican-controlled Congress.

Overall, fear currently dictates dislocation in real estate markets despite positive month-over-month economic news and solid real estate fundamentals, including high demand and occupancy rates with lower supply in many sectors.

These fundamentals and continued economic growth may extend today’s real estate cycle and provide total-return opportunities for long-term investors buying at a discount.

This information is educational in nature and does not constitute a financial promotion, investment advice, or an inducement or incitement to participate in any product, offering or investment. It is not intended to be used as a tool to determine your specific financial situation, tax status, investment objectives, investment experience, suitability for any specific investment, risk tolerance or investment profile. Resource is not adopting, making a recommendation for or endorsing any investment strategy or particular security. The materials included herein are the property of Resource and may not be repurposed in a separate likeness without the express written consent of Resource.

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