Trends Watch: September 7, 2017
EisnerAmper’s Trends Watch is a weekly entry to our Alternative Investments Intelligence blog, featuring the views and insights of executives from alternative investment firms. If you’re interested in being featured, please contact Elana Margulies-Snyderman.
This week, Elana talks to David Rosenberg, Portfolio Manager, HGI Capital Management, LLC.
What is your outlook for the economy and for real estate securities?
Despite numerous setbacks and a lack of progress to date, we believe several of the Trump administration’s pro-growth initiatives will be achieved over the coming 12-24 months, which should drive corporate spending and further economic activity. HGI Capital Management expects annual job growth of +1.5% and GDP growth in the 2%-2.5% range. U.S. 10-Year Treasury Yields have stabilized in the low 2% area and we expect rates to remain in the 2.25%-2.75% range through the remainder of 2017. Based on these assumptions for the economy and capital markets, we believe that property-level cash-flow growth of 3.5%-4% for well-located properties in the U.S. can be achieved, ultimately driving REIT values 8%-10% higher after factoring in external growth opportunities. When considering the 5%-10% NAV per share discounts that core REIT sub-sectors trade at today, we believe many REITs and real estate-related securities are positioned to deliver a 10%-20% total return over the next 12-18 months. We understand the key to the vitality and length of the real estate cycle hinges on the level of new construction. While new supply has increased above trough levels, the current level, as a percentage of inventory, is only at 40% of historical levels and should enable economic growth to drive both occupancy rates and positive rent growth higher.
What are some opportunities that you see in the real estate securities space?
We see opportunity in three areas: (1) bottom-up, catalyst-driven opportunities; (2) thematic, top-down sub-sector and geographic ideas; and (3) deep value “margin of safety” investments where valuation itself serves as a catalyst. Although fundamentals in the office sector have decelerated in recent quarters, we believe valuation levels are supportive of certain REITs with assets in the appropriate markets which stand to benefit from near-term leasing catalysts. We have a favorable top-down view on the U.S. rental market and believe a majority of new household formation in the U.S. continues to target rental units as the national homeownership rate remains near multi-year lows. That said, recent housing data seems to support a bottoming in the homeownership rate, which over time could begin to absorb some existing rental demand.
What keeps you up at night?
What keeps me up at night are the variables that are simply impossible to underwrite and forecast. In our firm’s view, there are three primary factors that drive real estate values: (1) property fundamentals, (2) investor demand, and (3) capital markets. With regards to property level fundamentals, HGI Capital Management looks to insight from its affiliate, Harbor Group International, a commercial real estate investment firm with “on the ground” intelligence in multiple real estate markets and properties. As it pertains to investor capital demand for real estate, we are currently tracking over $275 billion of unspent dry powder capital sitting on the sidelines, which is committed to be invested in commercial real estate globally over the next 12-18 months. This significant sum can clearly support current asset values and then some. However, it’s the capital market (particularly the bond market) which is a constant moving target and any meaningful shift in interest rates over the short term can impact real estate and REIT pricing in the near term. Bond yields are influenced by both inflation as well as demand from foreign investors, and an unanticipated change in rates could impact valuations rather quickly. Being liquid and maintaining positions sized to nimbly react is key to taking advantage of new or unexpected paradigms.
Despite uncertainties as to near-term prospects for real estate and REITs given the upward trajectory of interest rates, we believe the REIT sector can perform well alongside strong property market fundamentals even in a period where the Fed is tightening and longer-term rates are increasing at a measured pace.
We recently analyzed the relationship of REIT performance with bond yields and concluded that the correlation has been low over the medium-to-long term. A higher correlation exists in shorter-term periods where interest rate spikes caused REITs and other income oriented sectors to correct, but this scenario has typically provided a meaningful buying opportunity at compelling valuation levels, and in most cases, has led to meaningful outperformance of REITs over the broader markets, in subsequent periods. Our analysis also revealed that in most cases where the Federal Reserve Bank increased short-term rates over the past 20 years, REITs generally delivered strong double-digit returns in the ensuing years.