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Date: June 27, 2017
Category: Real Estate

Q1 2017 Real Estate Report: Today’s Market Demands Active Management

Real estate market active management

While we believe the outlook for real estate remains broadly positive, a potential deceleration in real estate earnings growth means that picking the right sectors and assets is more important than ever. Against the backdrop of buoyant markets and rising animal spirits, investors must actively seek out pockets of true value.

Since the depths of the Great Recession in 2009, U.S. equities have enjoyed a largely uninterrupted bull market. In the fourth quarter of 2016, it seemed that unanticipated events might throw markets off their upward trajectory. Donald Trump won an unforeseen victory in the U.S. presidential election, the Federal Reserve began its long-delayed rate tightening cycle, and the United Kingdom unexpectedly voted to exit the European Union. However, after some brief jitters,markets shrugged off the uncertainty these events generated and rose sharply.

S&P 500 performance active management

This so-called “Trump bump” has been driven, in part, by anticipation of the stimulatory policies Trump promised to implement. Markets have been encouraged by Trump’s talk of tax reform, massive infrastructure spending, and the potential repatriation of offshore corporate profits. Although these measures have not yet been implemented, markets appear to be pricing them in together with robust GDP and earnings growth.

Upbeat markets and a growing economy are broadly positive for the real estate sector. As the economy grows, demand for apartments, office space, warehouses, and storage grows, lowering real estate vacancy rates and potentially boosting rental income.

Encouragingly, despite robust demand, most sectors have seen only modest new supply, so oversupply does not threaten real estate’s generally positive outlook.

In keeping with this supportive environment,in the first quarter, traded real estate investment trusts (REITs) reported robust earnings in-line with earlier guidance. Looking forward, however, some REITs anticipate a deceleration in earnings growth. Whereas last year traded REITs were forecasting 2016 earnings growth in the 4–6 percent range, they are forecasting growth of 2–4 percent for 2017.

Interest rates are a likely driver of this deceleration. As rates rise, the cost of borrowing rises, and this can mean potentially lower earnings for certain real estate holdings, which must redirect rental income to higher interest payments. In response, fear drove a modest correction in the traded REIT sector in late 2016 when the Federal Reserve raised rates.

From our perspective, however, this correction has merely served to improve the attractiveness of traded REIT valuations. Market concerns about the impact of rising rates on real estate are largely misplaced. Typically, landlords have the ability to pass increased interest costs along to tenants through lease renegotiation and rent-escalator clauses. This is particularly true for sectors with short-duration leases like multifamily.

Real estate market index correction

In other words, while real estate earnings growth may be slowing overall, we believe that individual REITs continue to offer value. For investors, this underscores the need for active management and careful investment selection.

While real estate earnings growth may be slowing overall, we believe individual REITs continue to offer value.

Consider the dynamics at work in individual real estate sectors. In the multifamily sector, for example, performance has been strong over recent years. Rental demand is high, driving low vacancy rates and strong rent growth. However, looking at the supply side, we see a mixed picture. In top-tier cities such as New York and San Francisco there has been intensive construction of luxury apartments concentrated in downtown areas. In contrast, in so-called 18-hour cities like Minneapolis and Austin, new construction has been much more limited.

For investors, this means that selecting a multifamily investment option is not black and white. Simply buying the market would mean potentially acquiring assets in locations where the growth outlook is muted by oversupply. In this environment, individual asset selection becomes important.

Looking ahead, we believe the outlook for real estate remains positive. The economy is growing and there is the potential for further stimulus as the Trump administration rolls out new policies. The deceleration in earnings growth simply means that active management and asset selection become more important in securing long-term returns.

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