Evaluating real estate investments, including real estate investment trusts (REITs), depends on evaluating three cycles: the economic cycle (primarily jobs), the building cycle, and the interest rate cycle
We believe we are in a good spot in the economic cycle for attractive U.S. real estate returns, with steady job gains and an improving domestic economic growth outlook. The building cycle for real estate shows little sign of the type of overbuilding that has ended previous cycles. Finally, although interest rates have risen modestly, they are likely to rise little more, if at all. Any increases would be driven by improving economic growth and a gradual pickup in inflation, conditions historically favorable for real estate stocks.
We believe real estate is well positioned for this stage of the economic cycle. Job growth has been steady, with an average of 195,000 jobs created monthly over the past 12 months. Jobs put workers in offices. Jobs give workers wages to shop in malls (or online), creating demand for warehouse space. Jobs enable workers to pay higher rents for their houses and apartments. And jobs help create inflationary pressure that gives real estate owners the pricing power to raise rents. These factors tie real estate to employment. This close relationship is evidenced by the 0.9 correlation between real estate stocks and total private employment, highest among the 11 S&P 500 sectors. Stock performance typically leads the job count by six months.
Although we expect job growth to slow in 2017, several factors suggest the potential for continued solid gains and support for real estate investments. Fiscal stimulus from tax reform, infrastructure spending and deregulation could help stimulate job growth, but probably not until late in the year. Consumer and business confidence are high, which tends to result in additional hiring. The employment component of the Institute for Supply Management’s manufacturing index is strong, having increased the five straight months to 56.1 (50 is the breakpoint between expansion and contraction). While the job picture looks good, some slowdown from the 2016 pace would not surprise us, especially considering the economic expansion is nearly eight years old and unemployment is near its expected long-term rate
Other cycle gauges we watch include the yield curve (the difference between short-term and long-term interest rates) and the index of leading economic indicators (LEI). These indicators, among others, suggest the cycle has further to go and additional gains for real estate lie ahead. And don’t forget interest rates are still low and the Federal Reserve (Fed) has only increased rates twice.
When assessing the building cycle, one important question to ask is whether the real estate industry is overbuilding. One consequence of the 2008-2009 financial crisis was that the supply of real estate was significantly constrained by the severity of the recession and reduced credit availability. The slower pace of building leaves the commercial real estate market in better supply-demand balance today than it has been at this stage of prior cycles. Case in point, the level of commercial construction in the latest gross domestic product (GDP) data, at $440 billion, is still only about halfway to the 2000 and 2007 peaks despite the $100 billion increase since the post-crisis trough in early 2011. Notably, the pace of construction has pulled back since 2014, further evidence of the lack of froth.
We do not see evidence of excesses in real estate lending markets. The latest Fed loan officer survey showed more tightening of commercial real estate standards than easing, although the survey showed less tightening over the last two quarters. Depending on the path of bank regulation, there could be further easing. What we are seeing in the data reflects disciplined lending practices. Commercial real estate loan delinquency data indicate a healthy market, with a delinquency rate of 0.87%, below the troughs of the 1990s and 2000s. A heathy market coupled with disciplined lending practices is a good combination.
Higher interest rates reduce the attractiveness of potential distributions offered by REITs, and they increase borrowing costs for developers. Consequently, real estate securities tend to underperform the broad equity market when interest rates rise. Somewhat higher interest rates, though, would not necessarily affect real estate values. The interest rate cycle is tied to inflation. Real estate owners can often raise rents in an inflationary environment. Higher rents support REIT dividend growth, which has historically exceeded the rate of inflation. Based on S&P Indices data, the income component of REIT returns has been more than inflation, as measured by the Consumer Price Index, in 15 of the last 16 years.
We should keep in mind, though, there is a great deal of uncertainty surrounding tax reform. While some change is likely and should improve the economic backdrop, some measures under discussion may have a negative impact on real estate. Of particular concern would be the elimination of the deductibility of interest on debt. And a border adjustment tax as part of tax reform may also increase the cost of construction. The timing and nature of tax reform remain a source of uncertainty.
Evaluating domestic real estate depends on evaluating three cycles: the economic cycle, the building cycle, and the interest rate cycle. Consistent job growth underpins a healthy real estate environment; we haven’t seen the type of overbuilding that has ended previous cycles; and should interest rates rise, any increases are expected to be modest. For the moment, these factors seem to benefit real estate investments.
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