Housing properties and real estate-related assets are subject to the risks typically associated with real estate, including, but not limited to, natural disasters, acts of war or terrorism, environmental issues, changes in governmental laws and regulations, and adverse changes in national and local economic and real estate conditions.
U.S. commercial real estate prices have never decreased outside of a recession.1 Entering the second half of 2018, the U.S. economy appears to be on steady ground despite fears of being late in the economic cycle. In the first half of 2018,2 1.3 million net new nonfarm payroll jobs were created, the largest job gain since 2015 which pushed down unemployment rates below 4%. On the heels of tax reform, Real GDP jumped 4% in the second quarter of 2018, and, we believe, indications are that the economic strength may continue through the rest of the year and into 2019. The performance in the economy has had a direct impact on the U.S. commercial real estate market. Absorption across the four major real estate asset classes (office, retail, industrial, apartments) has been positive with retail lagging the other groups (but still positive) due mainly to concerns around e-commerce and oversized stores.
Figure 1: Cap Rates Compared to Interest Rate Movements
In addition to driving absorption within the U.S. real estate market, job growth is resulting in upward pressure on wages. This, coupled with new trade policies pushing higher prices and construction costs, could accelerate inflation and Fed tightening. Although interest rates have increased during 2018, it has not had an impact on U.S. commercial real estate pricing yet.4 As seen in Figure 1, cap rates have not followed the path of long-term interest rate movements, but there is a flattening that has begun in 2018.
With the economy near full employment and wage pressure ticking higher, household incomes are increasing and that could boost future housing demand. We have seen home ownership rates increase over the past year ending June 30, 2018.3 Supply for the most part is in balance with the exception of some luxury multifamily markets where short-term deliveries exceed demand,3 but, we believe, long-term fundamentals still look attractive given demographic trends and credit discipline.
From the demand side, we see three key demographic groups as having an impact on housing demand.
First, the size of the Millennial Generation (born between 1985 and 2004). Adults under the age of 35 formed 10.5 million new households from 2012 to 2017, 1.5 million more than the previous five-year period.5 Further, over 30% or approximately 23 million adults between the ages of 18 and 34 are still living at home, which may result in pent up demand once those young adults ‘leave the nest’ and start forming additional households.3 Overall, the Millennial Generation may account for 49.8 million households by 2035, compared to only 16 million in 2015.5
The second factor we believe is driving demand is immigration. Despite current immigration policies, net immigration may average 1.0 million annually over the next decade.5 As a result, immigrants may increasingly have an impact on the demand of household growth.
The third demographic factor we believe is driving housing demand are the Baby Boomers (born between 1946 and 1964). The segment of the population that is 65-74 years old is the fastest-growing age group in the U.S.5 Housing needs may be changing as they age, driving potential investments into existing homes, as well as potentially moving closer to family in urban areas.
Collectively, these factors may account for household growth over the next three to four years to levels above those achieved over the past six years, as seen in Figure 2.
Figure 2: Projected Annual Household Formation
In terms of supply, despite the recent flood of new apartment deliveries over the past three years, the housing market is still generally under-supplied relative to household demand.3 Even after seven consecutive years of growth in new residential property supply, the U.S. has added less new housing over the past decade than at any 10-year period dating back to at least the 1970s,6 and annual supply remains below long-term annual averages, as outlined in Figure 3. We believe, a decade of historically low single family construction may provide room for expansion in this sector of the housing market and the multifamily deliveries remain just below historical averages.
Figure 3: Housing Supply
In 2017, the supply of for-sale homes averaged only 3.9 months, which is below the 6-month threshold considered as a balanced market. Single family starts totaled 849,000 units in 2017, below the long-run annual average of 1.1 million.5 One reason why supply has remained low is due to availability of buildable lots. According to Metrostudy data, the inventory of vacant lots in the 98 metro areas fell 36 percent between 2008 and 2017. Further, 21 of the nation’s 25 largest metros reported inventories that would support less than 24 months of residential construction (24 months is often considered equilibrium for lot supply).
In the multifamily segment of the housing sector, luxury apartments in major metropolitan areas are pushing vacancies higher due to a flood of new units over the past three years. Although vacancy has increased slightly in 2018 due to an increase in supply (especially in urban areas), the national vacancy is still near historic low levels driven by an average increase of 1 million new renters per year between 2012 and 2016.6 There are some reports that suggest that the United States may need to add over 4.6 million new rental units by 2030 to meet the demand.6 However, multifamily construction is starting to moderate with starts down 10% in 20175 as lenders pull back on advance rates and increased construction costs make it difficult to make transactions pencil. Further, we have some concern whether renters can afford the rents of apartments currently under construction and those in the planning stage. As outlined in Figure 4, CoStar’s analysis of affordability paints an interesting picture. Most markets outlined in Figure 4 do not have the in-place median income to support the expected rents in newly constructed apartments. This affordability issue could place a governor on future development in certain markets, which could lead to continued supply/demand imbalances.
Figure 4: Income versus Rents
Overall, we believe the long-term fundamentals of the housing sector make it a compelling sector for investment driven by strong demographic tailwinds.
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Investment advisory services are provided by Platform Investments, LLC (“Platform Investments”), a wholly owned subsidiary of Platform Ventures, LLC. Platform Investments is an SEC registered investment adviser with its principal place of business in the State of Kansas. Registration of an investment adviser does not imply any level of skill or training. Securities offered through North Capital Private Securities, member FINRA/SIPC.