US Real Estate Insight – Q3 2017

October 23, 2017

When looking at real estate as an asset class it is important to look at the geographic location, this will help make sense of the comparison to other assets with similar characteristics. Each area and each country has a different set of demographics, determining what demand for properties there will be. In the US working-age, populations thrived in cities with high-growth technology jobs such as San Jose, Portland and Austin. Working-age population growth can generally predict office demand growth over the long term. GDP is also a measure but not as closely correlated to demand as the working-age demographic.

Slowing growth in working-age populations does not however end in disaster for commercial real estate investment returns, even though growth is closely correlated. Developers will overshoot demand on occasion but they can also pull back and let demand catch up once again. The problem generally lies not in slow growth in working-age populations but in negative growth thereof, which is very different to slow growth. Of course the other side of a declining working-age population is an increasing older population which brings with it unique demands and opportunities (here we think retirement communities and assisted living).

Consecutively from December through to May, the most recent month for which data is available, national home prices set new highs. Home price growth has outpaced wage growth and inflation so more than half of homeowners expect home prices to decline in the near term (approximately two years). Over the past five decades, home price cycles have tended to last seven to ten years with the last bull-cycle lasting an exceptionally long 17 years before home prices crashed spectacularly in 2006 and then finally began a sustained rebound in 2012. Is this a bubble or just the higher end of the cycle? Excessive lending seems to have been curtailed and in addition, it is healthy for property buyers to show a little bit of scepticism. Moreover, people should look separately at property as an investment versus a place to live, although buying makes sense compared to paying rent.

Now when we turn to US Real Estate in more general terms we see some signs of it being expensive compared with Australia, Britain, Canada, France, Hong Kong, Japan and Singapore Just to emphasise, a REIT has to elect and qualify as being a REIT in terms of taxation rules and the pass-through principle applies where REITs avoid most entity-level federal tax by complying with detailed restrictions on its ownership structure, distributions and operations. REIT shareholders are taxed on dividends received from a REIT.

Publicly traded REITs are typically corporations or business trusts. REITs have performed well since the 2008/9 crash in the US housing markets, and commercial property prices have long surpassed their 2008 pre-crash peaks with mortgage lending loosening up once again as banks make it easier for mortgage applicants with current mortgage rates still relatively low to historical standards. Lenders have armed themselves with better lending models and are buoyed by the rising US housing market.

It is also important to understand the difference between investing in property directly or via a platform like a REIT and over the past 5 years, REITs have had an average annual return around 9% while the average annualized return of direct real estate investing is at-or-below 8%, whilst much broader diversification is obtained investing though a REIT. Open-ended property funds as opposed to REITs (which are closed-ended) come with their own unique risks when using one of these to invest in property as property can be illiquid when you have to sell the actual property to redeem units i.e. to destroy units in the open-ended fund upon redemption requests and the open-ended fund can never fully invest all cash as they have to anticipate some smaller redemption at all times. Often times in an open-ended fund a buying opportunity can result in fund suspension or even dissolution/liquidation, the exact opposite of what people want to achieve in a buying dip.

Self-Storage REITs, in general have shown gains in revenue, net operating income (NOI) and occupancy (examples: Strategic Storage Growth Trust Inc. (SSGT) and Strategic Storage Trust II Inc. (SST II), both public, non-traded, self-storage real estate investment trusts (REITs) sponsored by SmartStop Asset Management LLC. Even increases in occupancy are seen in the reporting figures of many self-storage REITs for example the five largest publicly traded, U.S.-based self-storage real estate investment trusts (REITs): CubeSmart, Extra Space Storage Inc., Life Storage Inc., National Storage Affiliates Trust and Public Storage Inc. The have all released financial statements for the quarter that ended June 30, 2017. In general, all five entities showed gains in key areas, particularly funds from operations (FFO) and net operating income (NOI), while also achieving increases in occupancy.

These self-storage REITs are also making use of their third-party management platforms that is continuing to expand rapidly. Third-party management of some self-storage facilities provides the benefit of branding and future acquisition opportunities. Looking ahead, we can note that all the growth we have seen over the past few years has been in the face of virtually no inflation, and typically, consistent growth clocked up by the self-storage REITs have been at least 2% to 2.5% above inflation. This leads us to the question: Are people in the US moving more?

High demand and low supply of space encouraged new construction and conversions leading to an uptick in new stores that include “third-generation” facilities that look like apartments or offices and include climate control in some cases. It is known that historically American workers are quite mobile, and often need a temporary spot to store their personal effects. Also short-term storage contracts are like bank deposits – it is contractually short term, but usually stays where it is. Self-storage also assists property owners with problem tenants or non-paying tenants more specifically.

Increases in first-time homebuyer share (of mortgage applications) are to be expected in the face of an improved economy, falling unemployment, and rising household formation and incomes. This has happened alongside an increase in new home construction and a decrease in the size of the average home. Per the Census Bureau, cumulative single-family housing starts totalled 260,000 in the first four months of 2017, in comparison to 243,000 and 209,000 during the first four months of 2016 and 2015 respectively. However, more importantly, the median square footage of newly built homes continued its downward trend and declined to 2,628 in Q1 of 2017 from 2,658 in Q1 2016 and 2,736 in Q1 2015.

Data seems to suggest that homebuilders are not only building more homes, but at the same time they are also more inclined to build smaller, less expensive homes, which are more likely than larger homes to meet the limited budgets of first-time homebuyers. Industry claims though that credit standards have increased since 2008 and that on a whole the US is seeing responsible lending and this serves as evidence that they have learnt from their mistakes in 2008.

Since the 1970s, of course, we have seen a marked increase in living space per person however; the average household size has decreased over that period from 3.01 persons per household on average in 1973 to a new record low of 2.54 persons per household in 2013, 14 and 15. US labour market tightness has failed to generate strong wage growth, which is a contributing factor to inflation being consistently below the Fed’s 2% target. Minutes of the US central bank’s July 25-26 policy meeting showed policymakers appeared increasingly cautious about weak inflation, with some urging against further interest rate increases.

Finally, Timber REITs, which own forest land and essentially in the business of growing trees for lumber, benefit from higher lumber prices, growing demand due to housing market growth and shrinking supply due to wildfires and damage from the mountain pine beetle. Timber REITs are thus benefiting from a stronger economy but at the same time is not directly correlated to common equities whilst still providing some income and inflation protection, and if lumber prices are too low you can keep the trees to grow into more valuable lumber when prices pick up again. When lumber prices are low, timber REITs and companies can withhold harvesting logs and let trees grow, and when prices rise they not only profit on the higher log price, but they make more money per tree since it is now larger – a feat very few commodities, if any, can return for you.

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