Macroeconomic fundamentals

The outlook for REITs and commercial real estate depends critically on sustained improvements in economic fundamentals. What are the risks that a recession is on the horizon?

Economic fundamentals for REITs and real estate continue to improve. GDP growth slowed in late 2015, but mainly reflecting a decline in energy exploration and in export markets; domestic sectors supporting real estate remain firm. 

The outlook for equity REITs’ operating performance in 2016 depends in many ways on the impact of rising interest rates. How much will higher interest payments affect earnings? How solid are REIT balance sheet positions? Will higher short-term rates cause any difficulties covering interest payments?

Total nonfarm employment rose 211,000 in November, following an upward-revised increase of 298,000 in October, showing a strengthening economy heading towards the end of the year. Labor market slack is much diminished from two or three years ago, with the unemployment rate unchanged at 5%.

The holiday shopping season is officially underway, with Black Friday for in-store sales and Cyber Monday for online purchases.  Sales during the holiday season are a critical factor in the outlook for the retail property sector. There are crosswinds in the outlook for retail properties, however, with continued but uneven macroeconomic growth, the near certainty of a rise in short-term interest rates and, especially, the growing share of e-commerce at the expense of bricks & mortar sales.

Apartment markets remain tight across the country. Vacancy rates ticked up 10 bps, from continued new construction as well as some slowing in absorption, but are still at rock-bottom levels. Rent growth accelerated to a 6% annual rate, as vacancy rates in the low 4’s indicate little or no slack in the market, giving landlords a strong position to increase rents.

The multifamily REIT sector has been on a hot streak the past few years, as record-high occupancy rates and solid rent growth have lifted net operating income and property valuations to new highs. The strong tailwinds for this sector stem in large part from the significant pent-up demand, or “shadow households”, currently doubled-up with roommates or parents.

Household formation has been stubbornly slow in recovering from the housing crisis. Recent data show, however, that a recovery is underway (finally)!

The 3rd quarter ended with property values in the U.S. down 7.9% since the end of 2014, with declines of 8.2% during 2015Q2 and 1.9% during 2015Q3 following the gain of 2.2% posted in 2015Q1, according to the FTSE NAREIT PureProperty Index Series.  The PureProperty series, an investable product launched on June 1 by FTSE Russell, measures capital appreciation and total returns on unlevered property investments in U.S. apartment, health care, hotel, industrial, office, and retail properties owned by listed U.S. equity REITs.

Nonfarm payroll employment rose only 142,000 in September, far below recent trends, and gains in prior months were revised down as well. There’s little good news in this report concerning the economic outlook, as there was no gain in average hourly earnings, and labor force participation slipped further, indicating that weak demand for labor is keeping some potential workers on the sidelines.