The March 10, 2020 episode of The RealNex Webinar Series featured Dr. Glenn Mueller who presented his Real Estate Market Cycle Monitor for Q4 2019. As a special add-on, RealNex Head of Data and Research, Dr. Jeffrey Fisher gave a brief report on the potential impacts of Coronavirus on real estate markets. Highlights from the session follow, while you can click the links to access the full session recording and presentation deck.
Dr. Mueller’s work monitors the performance of the top 54 domestic USA real estate across a 4-quadrant continuum of market stages:
- Recovery - reflecting declining vacancies and no new construction
- Expansion - reflecting declining vacancy with new construction
- Hyper-Supply - noted by increasing vacancy and continued new construction, and
- Recession - decelerating vacancy and continued construction deliveries
The key drivers focused on were: GDP Growth, Employment Growth, Inflation and Interest Rates. GDP has been running steadily at its long-term potential and was expected to continue apace if not for Coronavirus shock to the system. Now, a short slow down is expected before returning to the 2% range. Employment growth is a healthy .9% or roughly 3,000,000 people. This is lower than the historical trend as baby boomers move into retirement, and the long run of job growth leaves fewer prospects on the sideline to be added. Inflation has been running at 2% and is expected to remain at that level. As far as the 10-year note, rates had been running in the 2% range until the recent flight to safety which has driven rates to an unprecedented level below 1%. Rates are expected to remain at historically low levels but tick up and remain in the 1-2% range for the next few years. Now in the 10th year of economic expansion, many are calling for a recession and with the impact of Coronavirus that is more likely, but prior to that exogenous event the expectation was for a continued slow growth, “Lower for Longer” expansion.
Through year-end 2019 all property types, except apartments, were in an Expansion phase of growth. Apartments were in the Hyper-Supply phase. Suburban Office was seen to be at the front end of the Expansion Cycle, while warehouses and community centers were at the last point in the Expansion Cycle.
The Market Cycle Monitor tracks specific geographic markets by product type. As far as the Office Market, Washington DC was the lone market in Recovery, while Austin, Houston and New Orleans were in Hyper-Supply. All other markets were in Expansion with only a slight bias to the later stage. Of note, Houston was impacted by the oil industry slow down reducing demand while Austin was characterized by solid demand but over-supply.
From an industrial perspective, the National Index was at the last stage of Expansion – at a virtual equilibrium. Indeed, 38 markets were seen to be at equilibrium, with 16 markets experiencing Hyper-Supply. The most advanced Hyper-Supply markets were Cincinnati, Ft. Lauderdale, Orlando and San Antonio.
Apartments were in a similar but slightly advanced mode, with 30 markets in equilibrium while 24 markets and the National average were in Hyper-Supply. Atlanta, Denver and Memphis were farthest along the continuum.
The retail market displays near exact equilibrium, with 52 markets at that stage. Only Honolulu and Jacksonville were in Hyper-Supply. The health of retail markets has been driven by massive re-purposing of supply, with conversions to residential, industrial and other mix of higher demand uses.
The market health is a result of rapid growth the demand since the Great Recession far outpacing new supply from 2011-2018. In 2019 new supply finally caught up and surpassed new demand, a trend that is expected to continue in 2020. This should result in occupancy levels peaking and leveling off at the current healthy level.
The Cycle Indicators would predict the following:
- Office – A move to the later stage of expansion with occupancy leveling off and he pace of rental rate growth decelerating
- Industrial – Peak Occupancy and rental rate growth. Expect growth to continue but at a slower pace.
- Apartments – Most markets past peak growth. Expect more rapid deceleration of growth.
- Retail – Peak Occupancy, expect moderate growth to continue with slow rental growth
Demand for real estate as a primary investment asset class is expected to remain strong. This hard asset with steady, growing cash flow remains an excellent alternative in a volatile equity and low yielding fixed income world. Since 1954 bonds have generated a 5.78% total return. From 1954 – 1981, they returned 3.9% as interest rates rose from 2% to 15%. From 1982 – 2019, the return was 8.31% as rates dropped from 15% to 2%. Now with rates at below 1% there is only one way to go and the result will look more like 1954-1981 with 3.9% returns vs. 1982-2019 with 8.3% returns. Further supporting the case for real estate investing is as a class it has experienced only 5 years of negative growth since 1934 while stocks and bonds have been much more volatile with 20 and 21 years of negative growth respectively.
From a current valuation standpoint, the industry continues to look healthy even at current peak levels. According to data from Real Capital Analytics, since the 2007 peak we are now up 34%. Indeed, all sectors are above the prior peak except Retail which is just 1% shy. Apartments have done the best now at 83% above the 2007 level. But even as cap rates drop, spreads to treasuries have expanded dramatically. In 2007 the average spread was in the 1.5% range, while today that spread is 4.5%. Further, the flow of global capital is at work. With cap rates for class A CBD office in London at 2% and Hong Kong/Singapore at 1%, New York’s 3.8% seems to be a bargain. This global pressure is pushing tiers of investors to move out from core markets to secondary and tertiary cities.
In sum, cycles can be short or long. We are currently in the longest since World War II. Dr. Mueller expects growth to slow but continue “Lower for Longer” with the impact of Coronavirus as a “Wild Card”.
As a timely add-on to the webinar, Dr. Jeffrey Fisher, RealNex head of research took a few minutes share a perspective on the impact of Coronavirus on the real estate sector based on work by Dr. Norm Miller.
While there are many unknowns, a few implications are massive disruptions to supply chains and devastating impact to travel and leisure. Beyond, hotels and conference centers, restaurants, bars, movies, theaters, and even fitness centers will experience a dramatic hit. There will be more telecommuting, which may have a lasting impact on office demand, and even more on-line shopping will further reduce retail traffic. Ports will be challenged but last mile industrial for e-commerce to thrive. The loss of “wealth effect” value in equities and shock to the system, with the strong possibility of recession, is expected to cause a temporary slowdown in investment and decision making, but with interest rates expected to remain low real estate show remain a healthy and preferred investment class.