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Date: January 31, 2017
Category: Real Estate

2017 Real Estate Outlook: Fundamentals Remain Strong

Interest rates real estate fundamentals

When considering real estate in a rising rate context, it is important to avoid generalizations, and to look closely at fundamentals and the overall environment.

In 2016, the real estate sector benefited from a strengthening economy, rising employment, continuing urbanization, and low interest rates. However, in the fourth quarter, we began to see some volatility in Treasury yields. This was sparked by the Federal Reserve and the widespread expectation that it would raise interest rates in December, as indeed it did, and that it is likely to raise short-term rates more quickly next year than was previously expected.

10 year Treasury yields interest rates

This volatility was amplified by the unexpected victory of President Donald J. Trump. Trump has made a number of pro-growth policy comments, promising to cut both corporate and individual taxes and to increase government spending. These stimulatory fiscal measures would mean an increase in federal debt and potentially an uptick in economic growth. Higher GDP growth would drive employment and demand, which would in turn drive higher inflation and lead investors to demand higher yields. In anticipation of this, yields on ten-year Treasuries rose around 50 percent in the final months of 2016, hitting the 2.40–2.50 percent range by year-end.

Real estate performance GDP growth

In other words, in the fourth quarter of 2016, we began the transition from a low-interest rate, low-growth environment to a potentially higher-growth, more inflationary environment with higher interest rates. Typically, when we enter a period of rising rates, there is an emotional reaction in real estate markets. Investors reflexively take the position that rising rates are bad for real estate, and we see REITs being sold off. However, this knee-jerk reaction is often a mistake. The true long-term correlation is not between real estate and interest rates, but between real estate and GDP growth. When the economy grows, real estate performs well.

An environment in which we have steadily improving GDP growth, modest inflation, and moderate, slowly rising interest rates is positive for real estate. In the past, these conditions have seen real estate not only perform well, but even outperform.

The key factor in how real estate responds to rising rates is the speed at which rates rise. If rates were to rise significantly faster than GDP growth, that could create potential issues not only for real estate, but for the economy more broadly. In such a situation, we would likely see rising inflation unaccompanied by economic growth, or so-called stagflation. However, this is unlikely. The Fed has been cautious in its approach to raising rates, and no credible experts anticipate the stagflation scenario materializing.

The base case then, which is widely anticipated by economists and market watchers, is a stronger economy with rates rising steadily in line with growth. This is a good environment for real estate. As the economy grows, most properties see vacancy rates fall and occupancy rates rise, and as inflation ticks up, rents may also rise, particularly for properties with short-term leases or consumer price index escalator clauses in their leases.

In addition to a positive operating environment, real estate fundamentals remain sound. On the supply side, despite an uptick in building last year, oversupply is not an issue. With few exceptions, new supply in most sectors is limited and just sufficient to replace obsolete buildings. Overall, new completions remain low at around 1.2 to 1.3 percent of existing stock.

In short, we believe the outlook for real estate is broadly positive. Economic growth, job growth, and rising incomes are likely to underpin healthy demand, while new supply remains limited in most sectors. There are few clouds on the horizon, and we believe that 2017 promises to be another good year for real estate.

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