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Q2 2018 Real Estate Report: Looking for Value as Interest Rates Come Into Focus

Real estate markets have become increasingly more efficient after an early overreaction to the pace of interest rate hikes, yet a mid-June dip shows they are still reactive in the short term to changes in monetary policy.

Increased expectations for four rate hikes this year caused short-term volatility, but long term, these rate hikes may serve to extend the protracted cycle and keep the economy from overheating.

This is good news for real estate, as economic growth produces increased demand while supply remains in check. In today’s current market, with muted supply across sectors, higher demand typically translates into higher occupancy, increasing rent growth, and growing balance sheets. Public real estate markets are adjusting to this positive dynamic after an early period of interest rate shock.

Real estate investment trusts still look undervalued compared to the underlying value of the real estate they hold. While the public real estate market historically traded at a three to four percent average premium to the asset value of its real estate, on June 1, 2018 it was trading at a 14 percent average discount according to Green Street advisors.

This disconnect between performance and fundamentals may present a buying opportunity. Fiscal stimulus may support an even stronger economy by year-end, and tighter lending practices continue to keep supply muted.

Monitoring the Fed’s rate path

Real estate equity has a greater correlation to the 10-year Treasury Yield than LIBOR (London Interbank Offered Rate). Short-term Treasury rates have risen quickly with investors’ expectations for tighter rate policy. However, as the latest jobs numbers attest, continued positive economic news will likely push the 10-year higher, providing an environment for real estate values to appreciate slowly.

[Related:Hear our audio summary of this Commentary]

If the Fed cannot ward off inflation, it may make sense to play defense on the equity side with short-duration holdings that adjust quickly to rising rates. With consumer spending on solid footing and unemployment hitting an 18-year low, more travel makes hotels attractive, coupled with a daily lease structure that can respond quickly to changes in economic growth.

Other sectors with short duration include apartments, which have year-to-year or even month-to-month leases, and industrial warehouses, which typically work with three-to-five-year leases and are benefiting from growth in ecommerce.

Examining opportunities across sectors

Industrial demand continues to grow with expanding supply chains working to meet customers’ ecommerce delivery needs. U.S. industrial markets absorbed 56.9 million square feet in Q1 2018, its fourth strongest start to a year in the last three decades. Ecommerce sales increased 16.4 percent in Q1, versus just 5.2 percent in retail and food, highlighting strong demand for warehouse space.

Multifamily supply-demand fundamentals show no signs of changing, especially in class-B properties. Apartment REITs posted 20-basis points in rent growth in Q1 2018, but improved affordability may be a stronger catalyst as rates rise. A record number of households are paying 30 percent or more of their income on rent.

On the other side, despite significant job growth, office demand is more muted. Many companies are shifting away from the traditional office model to telecommuting and consultancy options, which utilize less office space. Retail, meanwhile, continues to feel the impact of ecommerce, with malls and shopping centers trading at double-digit discounts to historic net asset value (NAV).

Outside short-duration core asset classes, opportunities are available outside traditional avenues. Movie theaters, charter schools, cannabis facilities, and senior and student housing may offer attractive total return opportunities with most of the capital still crowding core sectors.

Active management in a time of transition

Is history a guide for future real estate performance? Back in 2004, the REIT market fell 15 percent as the Fed began raising rates, only to rise 78 percent through 17 rate hikes over the next three years. In this climate, real estate seems to be in a fundamentally stronger position than at the same point in the last cycle.

Yet, challenges remain. Positioning portfolios with allocations to floating-rate real estate credit investments may help offset dampening REIT dividends compared to the higher-yielding bond market.

The divergence in real estate sector performance may also be an opportunity for investors. Those searching for beta exposure to real estate may look to diversify across sectors for lower year-to-year swings in relative returns, while active managers with a deeper understanding of what is driving specific sector outperformance may be able to uncover alpha by taking advantage of public markets.

Resource Securities LLC, Member FINRA/SIPC.
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