Rising Mortgage Rates Adds New Twist To Real Estate Markets
- Amid a wild month of volatility, this week was rather tranquil. REITs finished roughly flat, on-par with the broader indexes. The 10-year yield topped 2.95% before retreating below 2.90%.
- Earnings season is nearly complete. 2017 finished strong for REITs, but 2018 guidance has been more conservative than expected. NOI growth has slowed but fundamentals remain healthy.
- Storage, industrial, and manufactured housing were the winners this earnings season. Supply growth continues to be a lingering concern in the residential, data center, hotel, and office sectors.
- Homebuilders dipped more than 2% as the 30-year fixed mortgage rate climbed to the highest level since 2014 and has surged more than 60bps since last summer.
- The effects of higher mortgage rates are beginning to trickle into the data. Existing home sales were weak in January as first-time buyers retreated from the ownership markets.
Real Estate Weekly Review
The wild volatility-driven swings that we experienced over the past month settled down this week as major indices and the 10-Year yield look to finish the week roughly where they started. The S&P 500 (SPY) and the REIT ETFs (VNQ and IYR) both finished the week roughly unchanged while homebuilders (XHB) finished the week lower by 2%. Mortgage REITs (REM) dipped nearly 3% while international real estate (VNQI and RWX) finished slightly lower. REITs are still more than 20% below their 2016 peaks and 12% below their recent 52-week highs in December.
(Hoya Capital Real Estate, Performance as of 1 p.m. Friday)
The 10-Year yield jumped to as high as 2.95% after the release of the Fed minutes before retreating below 2.90% on Friday. Inflation expectations continue to be the driving force behind movements in interest rates. REITs are still more than 20% below their 2016 peaks and 12% below their recent 52-week highs in December.
Within the Equity Income categories, we note the performance and current income yield of the Utilities, Telecom, Consumer Staples, Financials, and Energy. Within the Fixed Income categories, we look at Short, Medium, and Long Term Treasuries, as well as Investment Grade and High Yield Corporates, Municipal Bonds, and Global Bonds.
REITs are now lower by 9% YTD, underperforming the 3% rise in the S&P 500. Homebuilders are off by nearly 6%. The 10-Year yield has climbed 46 basis points since the start of the year.
REITs ended 2017 with a total return of roughly 5%, lower than its 20-year average annual return of 12%. Going forward, absent continued cap-rate compression, it is reasonable to expect REITs to return an average of 6-8% per year with an annual standard deviation averaging 5-15%. This risk/return profile is roughly on-par with large-cap US equities.
Real Estate Earnings Update
More than 90% of REITs have now reported 4Q17 earnings with a handful set to report next week. This week, the docket included Realty Income (O), Store Capital (STOR), Public Storage (PSA), CyrusOne (CONE), QTS Realty (QTS), ExtraSpace (EXR), Sun (SUI), Verret (VER), HCP (HCP), Healthcare Trust (HTA), Host Hotels (HST), Welltower (HCN), and Spirit (SRC). The full list, and the relative performance in the trading day after reporting results, is presented below.
While 2017 finished fairly strong for REITs, indicated by the 85% of REITs that either meet or beat expectations, 2018 is widely expected to be a slightly tougher year as the real estate cycle continues to mature. Same-store NOI growth averaged roughly 3% in 2107, down from the 4% rate earlier in the cycle. For 2018, we estimate that SSNOI will average 2.6-3.0%, still above the inflation rate but not by much.
Less than a quarter of REITs provided 2018 guidance above expectations. Supply pressures continue to encumber the residential, office, storage, hotel, and data center sectors. Higher expenses are widely expected to pressure NOI across the real estate sector from rising property taxes, higher wages for workers, and higher utility prices. Demand remains the wild-card, and REIT guidance appears to be more conservative on demand than the consensus among macro-economists. The REITs that were forced to revise down guidance in 2017 were punished by investors (student housing in particular), and we think that this is leading to overly conservative guidance forecasts that are easier to revise upwards in subsequent quarters.
On a sector-by-sector-level, retail REITs saw a continuation of the bifurcation trend between high-quality and lower-quality assets. Top-tier mall and shopping center REITs reported a solid holiday season, but lower-quality portfolios continue to struggle with occupancy and rent pressures. In the residential sector, apartment REITs reported firm demand but lowered their outlook for 2018 amid continued oversupply in several markets. Rent growth appears to have stabilized but we are not out of the woods yet as 2018 is expected to see a cycle-high 2% supply growth before waning into 2019. Student housing saw similar issues with oversupply. Fundamentals in single-family housing and manufactured housing were more solid as supply continues to be moderate.
Healthcare REITs continue to see weakening fundamentals in the senior housing and skilled nursing space, but hospital fundamentals continue to be resilient. Storage REITs reported better-than-expected results as sentiment appears to have gotten overly bearish amid supply pressures. Office and hotel REITs reported mixed results that were a bit underwhelming considering the strong economic backdrop that these sectors are levered to.
In the e-REIT sectors, industrial REITs reported strong results that topped already high expectations. Data center results were choppy as there are continued concerns over the impact of hyperscale (Amazon (NASDAQ:AMZN), Google (NASDAQ:GOOG) (NASDAQ:GOOGL), Microsoft (NASDAQ:MSFT), Oracle (NYSE:ORCL)) on the pricing and competitive dynamics. American Tower (NYSE:AMT) and SBA (NASDAQ:SBAC) report next week in the cell tower space, which has been in focus in recent weeks after the Space-X launch which reignited discussions over the (unlikely) possibility of satellite internet becoming an alternative for cell networks.
Real Estate Economic Data
(Hoya Capital Real Estate, HousingWire)
Mortgage Rates Reach Multi-Year High
The 30-year fixed mortgage rate, a critical benchmark in the homeownership markets, rose to its highest level since early 2014 this week. Fixed mortgage rates tend to move in synchrony with long-term Treasury yields, particularly the 10-year yield, which has shot up more than 50 basis points since the start of the year and 60 bps since the passage of tax reform.
Mortgage rates are an important input in a household’s decision to buy or rent. A 50 basis point increase in mortgage rates (from 4.0% to 4.5%) translates into a roughly $900 rise in annual mortgage payments on a $250,000 loan. Below we show our Hoya Capital Buy vs. Rent Index. We estimate that homeowners now pay a 10% premium in annual housing costs relative to renters for an equivalent housing unit. We believe that this has the effect of supporting rental rates and putting downward pressure on house prices.
Weak Existing Home Sales in December
Last week, we analyzed housing starts and permits data, which showed a fairly solid start to 2018. Existing home sales data, however, was weak in January. Existing homes were sold at a 5.38 million seasonally-adjusted-annualized-rate in January, well below expectations. This was 4.8% below last January, the largest SAAR decline in more than three years. Existing home sales were strong in early 2017 but faded into year-end, likely due to rising mortgage rates and continued tight supply levels. Sales remain higher by 1% on a TTM basis.
This rate of existing home sales, however, remains healthy by historical standards. Too many existing home sales (as we saw from 2003-2006) indicate that either mortgage standards have gotten overly loose or short-term housing flipping activity has increased. At around 7% per year, the turnover rate of existing homes is roughly in line with pre-2000 levels.
Existing home inventory remains near historically low levels, primarily a result of the tepid pace of new home construction in the aftermath of the recession. Existing housing supply was just 3.4 months in January, down from 3.6 months in January 2016. Other effects are at play, too, including the increased institutional presence in the single-family rental markets and the rising rate of homeownership among the older demographics. First-time homebuyers made up 29% total existing home sales, down from the 32% in January 2016. The rate of first-time homebuyers remains stubbornly below the pre-bubble level of 40-45% and the bubble-peak of 52%. We have yet to see the younger demographics enter the homeownership markets in any significant numbers.
The major home price indexes continue to show a steady 5-7% YoY rate of home price appreciation. Home prices have risen at least 5% YoY in every month since late 2012. As we often point out, rent growth has risen far more moderately than home prices over the past five years. The economics of renting are more attractive than owning for the majority of potential first-time homebuyers based on these statistics. All else equal, higher mortgage rates should be expected to put downward pressure on home prices. We expect home price appreciation to come in lighter in 2018 than in years past.
Amid a wild month of volatility, this week was rather tranquil. REITs finished roughly flat, on-par with the broader indexes. The 10-year yield topped 2.95% before retreating below 2.90%. Homebuilders dipped more than 2% as the 30-year fixed mortgage rate climbed to the highest level since 2014 and has surged more than 60bps since last summer. The effects of higher mortgage rates are beginning to trickle into the data. Existing home sales were weak in January as first-time buyers retreated from the ownership markets.
Earnings season is nearly complete. 2017 finished strong for REITs, but 2018 guidance has been more conservative than expected. NOI growth has slowed but fundamentals remain healthy. Storage, industrial, and manufactured housing were the winners this earnings season. Supply growth continues to be a lingering concern in the residential, data center, hotel, and office sectors.
This week, we published our quarterly report on the Data Center sector: It’s All About Hyperscale. The growth of the hyperscale public cloud providers, including Amazon, Google, and Microsoft, continues to be a long-term competitive risk. For now, they have a symbiotic relationship with these REITs. The boom in demand for data center space has been met by an equal boom in construction activity. AFFO growth has slowed as competition has heated up significantly since 2014. 4Q17 earnings were generally in line with expectations but guidance was conservative. Leasing activity continues to be light and choppy but pricing has remained firm and EBITDA margins have improved.
We also updated our report on the Student Housing sector: Student Housing Fundamentals Remain Challenged. Supply growth has outpaced enrollment growth in each of the past five years, which has weakened fundamentals. The demographic boom of college-aged Americans peaked in 2011. A strong economy, rising wages, and increasingly negative attitudes towards traditional liberal arts college curriculum have resulted in declining enrollment. Development remains the modus operandi and growth engine as both REITs have expanded their portfolio by roughly 10% per year. Institutional demand for student housing assets remains strong. Despite the short-term valuation dislocations, the long-term secular growth story appears intact. Cash-strapped universities will increasingly utilize private-public-partnerships to modernize their aging stock of dormitories to remain competitive.
So far, we have updated our quarterly reports for the Apartment, Mall, Data Center, and Student Housing sectors. We will continue our updates, which analyze the most recent earnings season, throughout the coming weeks.