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Q3 2018 Real Estate Report: Rising Rates and Economic Growth Find Balance in the Markets

There is good economic news, then there is the second quarter GDP number that rippled through the markets. By any measure, a 4.2 percent growth rate is a positive development – in real estate, an expanding economy equates to higher demand for space, and in turn, lower vacancy and higher rent growth.

With unemployment sitting below four percent for the first time in 18 years, more people are working, and with August’s release of 2.9 percent year-over-year hourly wage growth, they are earning more doing it.

This economic expansion is contributing to the Federal Reserve’s current interest rate policy: a view that slow-but-steady rate increases will help to keep inflation at bay without overheating a tight labor market. Interest rates serve as a counterbalance to economic growth, as borrowing costs for prospective buyers increase. Concern over this impact was felt in public real estate markets as recently as February, as a massive sell-off followed a 40-basis point spike in the 10-year Treasury. Since that initial dislocation, real estate markets have become increasingly more efficient, following solid sector fundamentals.

Real estate values are modestly rising, as cash flow growth is offsetting increases in the cost of capital. In fact, the compression of the spread between triple B-rated corporate bonds relative to market capitalization rates shows that investors are willing to accept a lower risk premium to invest in real estate.

The real estate cycle’s seventh-inning stretch

While commercial real estate is getting later into its current cycle, there remains attractive opportunities to find value. Moreover, while we are seeing higher borrowing costs, fundamentals look stable with sector-specific cash flow growth and manageable new supply coming online. To this end, we expect higher borrowing costs, along with higher construction costs, to make incremental building cost prohibitive and keep new supply in check.

If a strong economy continues, rent growth should continue its trend. Leasing activity is still robust, although there has been less available space to lease since late 2015, when a lot of excess vacancy was leased out. While it has slowed, rent growth is still exceeding inflation.

Taking a look across sectors

While the public markets generated positive results, several sectors faced headwinds. Self-storage struggled as the absorption of new supply negatively impacted asset values. Office was down despite strong job growth. Companies typically make office capital expenditure decisions four-to-six quarters ahead of hiring workers into the space they lease.

However, there are no bodies left in the labor pool, with even fewer immigrants coming to the U.S. for jobs due to more restrictive immigration policies. This shrinking talent pool will continue to hamper plans for office expansion.

Multifamily finished the quarter higher as new supply coming online did not impact rents and asset values as much as expected. Earnings came in much stronger than anticipated, and higher wages have improved apartment affordability and have enabled landlords to increase rents without the fear of lower occupancy rates.

Finally, industrial was slightly higher for the quarter, as fundamentals remain strong in the age of ecommerce and intricate supply chain. Occupancy rates of properties owned by industrial REITs increased to 97 percent – the highest among REIT property types – compared to 93 percent five years ago.

And rent growth for the national logistics sector has now remained above six percent for the past four years. Industrial performance, however, was dampened somewhat by the increasing threat of a trade war with China and capital fund flows out of overweight industrial positions in both ETFs and mutual funds.

Summary

Real estate markets are finding their equilibrium between rising interest rates and economic growth. After an initial interest rate shock, real estate has recovered, with higher asset values and strong returns in the public markets. Supply is moderate, but impactful, and rent growth remains positive as the market enters the late stages of the real estate cycle.

 
Resource Securities LLC, Member FINRA/SIPC.
 
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