The real estate market is in the fourth year of recovery since the 2009 mortgage crisis, rising over 30 percent since 2012, and many investors worry that it is time for a correction. Nevertheless, both historic macro-economic drivers and structural changes of the US real estate market point towards continued, but moderating growth: Morgan Stanley’s 2015 Real Estate market outlook projected that the US real estate market will grow 4% – 6% (MS Housing Market Insights 2015). Investors though have to be more selective in choosing the right real estate opportunities, since most of the post 2009 correction has already occurred.
Background: From Crisis to Recovery
Post the 2009 mortgage crisis, US real estate experienced an unprecedented set back with prices falling on average 30% with some markets such as Florida and Arizona dipping down 70%. Wisely, the US government and Federal Reserve jumped in with loose monetary policy to prevent the collapse of the system and minimized the impact to home owners. Big institutional and foreign investors swooped in to acquire US real estate at bargain prices. Than retail investors joined and in 2012 housing prices turned upwards. Inflation adjusted US housing prices have appreciated more than 50% on average since 2012, returns commensurate to US equites (see picture below):
Another indicator of real estate health, existing homes for sale and the average month supply of available properties for sale has also stabilized:
Finally, housing affordability remains well below historic averages:
Source: MS Housing Market Insights 2015
Investors know that real estate is cyclical and are beginning to wonder when the next correction will occur. Investors’ jitters are further enhanced by expectations that the US Fed will raise interest rates. However, I see little reason to be concerned, for now:
Both Historic Macro Economic Drivers and Structural Changes to the Real Estate Market Support Continued Growth:
To understand what will drive real estate markets one needs to look at both historic macro-economic drivers and structural changes that may impact supply and demand. An example of a historic macro-economic driver that impacts real estate valuations is interest rates changes; interest rates have a direct correlation to both home-ownership affordability and REIT pricing. Structural changes on the other hand do not have a historic precedent and cause markets to behave differently than investors would expect them to behave if solely relying on historic patterns. Structural changes include technological innovation, demographic shifts, political instability, changing cultural preferences and value, etc. I recently wrote an article on why structural changes in the supply equation have pressured oil prices down and made the heydays of over $100 oil prices unlikely to return any time soon (Do Falling Oil Prices Foreshadow a Slump in the Stock Market?). Similarly, in case of US real estate, a combination of historic macro-economic and structural factors are impacting prices that support current pricing on average and provide specific opportunities to generate alpha. Thus the probability of US real estate prices remaining buoyant for the next one to three years is larger than that of a decline.
Historic Macro Drivers that Support Real Estate Prices:
Driver 1: Interest Rates May Not Go Up As Fast or As High is Investors Feared
Real Estate in general and REITs in particular are sensitive to interest rates as they act as income generating vehicles and compete with bonds. When interest rates and bond yields increase, and REITs sell off because they arguably carry more risk than say, treasury bonds. Recently, however, REITs might have been oversold in anticipation of the US Fed raising interest rates and tightening monetary policy. The Dow Jones Equity REIT total return index fell more than 11% since January:
However, the market might have overreacted and the recent dip may be an opportunity to buy. US Economic data, including the revision of quarterly GDP from 0.2% to a negative number, as well as fears of stifling the US and global recovery (Ray Dalio Warning Against a 1937 Scenario) will likely lead to a delayed onset of and slower path for rate hikes.
Additionally, even with hikes, interest rates in the US remain at unprecedented low levels. It has never been so cheap to get a mortgage in the United States:
That coupled with eased mortgage landing and Fannie Mae, Freddie Mac and the FHFA guaranteeing some mortgages with down payments of as little as 3% will likely continue to support real estate growth (for now). Arguable, the long term impact of very loose lending practices could be disastrous, but let’s hope that policy makers have learned how better to strike the right balance.
Driver 2: The strong dollar and the still low interest rates in the US allow for foreign currency hedging and interest rate arbitrage for some foreign investors.
The strong and likely to continue appreciating US dollar as well as low mortgage rates (see above) are attracting sophisticated foreign investors. Shahzad Janab, a prominent Dubai hedge fund manager, whose fund Daman Investments has posted annual returns in excess of 40% for the last three years, finds the US real estate market and in particular the New York market attractive not only from a wealth preservation perspective but also as a currency hedge to the local currency and an opportunity to arbitrage the unpreceded low interest rates. “There are different ways to make the currency and interest rates bets, but combined with other factors, US real estate looks particularly attractive” shares Mr. Janab. A number of his colleagues are likely to follow.
Structural Changes that are Creating Specific Real Estate Investment Opportunities:
Driver 3: The US is experiencing a two way demographic shift which is driving up demand for multi-family rentals and boosting city living.
The two largest US generations – the Baby Boomers (75 million) and the Millennials (75 million) are simultaneously undergoing social transition. Both generations are shaping the future of real estate demand in the US and are simultaneously defying convention and thus creating real estate trends that are novel.
Source: Pew Research Center. Millennials – 1981-97; Generation X – 1965 – 80; Baby Boomers – 1946 -64; Silent – 1928 – 45; Greatest Generation – before 1928.
The baby boomers are close to retirement, have now raised their children and do not need the large homes, and in some cases, mansions, they moved into the 90s. While they are downsizing to more manageable residences, the baby boomers are not interested in retirement homes. Thomas Briggs, a real estate fund manager and developer in the North East and Florida, reports an over saturation of retirement type of facilities, overbuilt in anticipation of aging baby boomers. Instead baby boomers have chosen to remain independent as long as possible, and with the advent of new medical technology and remote monitoring, that independence is possible. They tend to move into smaller houses and apartments closer to city and town centers with easy access to social and cultural life. Boomers also tend to want to be closer to their children, driving demand for both multi and single family home ownership and rentals. The trend is driving demand in down town areas in the traditional 24 hour cities (New York, San Francisco) and also in the newly coined term – 18 hour cities (Denver, Slat Lake City, Atlanta), reports PWC (PWC Real Estate Outlook 2015).
Similarly, the millennials are not following the established patterns of prior generations, and, even though they have now started families, they are postponing the buying of a house and are often not moving to the suburbs. They tend to rent longer and are staying in smaller properties or even living with their parents. Partly, this is due to the millennials being spooked by what happened to their parents’ net worth in 2009, and thus they do not buy into the dream past generations shared of home ownership as the preferred way to amass wealth and gain stability. Additionally, the millennials are struggling financially because of high student debt burden and poor job prospects. Thus, millennials are becoming the permanent renter generation:
Source: US Census, Morgan Stanley Research, MS Real Estate Insight 2015
Thus both baby boomers and millennials are likely to perpetuate the demand for renting vs buying, for city living and for smaller properties. These trends would be most pronounced in geographic areas where these two generations tend to represent a higher percentage of the population including San Francisco, Seattle and New York among others (see chart below).
Driver 4: A flight of wealth from politically unstable regions to the US is propelling the US real estate market upwards.
To prosper, markets need stability with a clear and enforceable rule of law and protection of private property. In the last two decades due to globalization, technological innovation, and investment, emerging markets have generated an unprecedented level of private wealth. So much so that emerging markets is hardly a suitable term which economists are now replacing with fast growth countries. For example, second only to the US, China has 2,378,000 millionaire households in 2013, a rise of 82% from the previous year and almost double the 1,240,000 millionaire households in Japan, according to the Boston Consulting Group Global Wealth 2014 report. The primary concern of the expanding high-net worth and upper middle class in Asia, South America, Middle East and Russia is wealth preservation as opposed to wealth creation. And wealth preservation is particularly tricky when fickle governments or risk of war are involved. I speak at multiple emerging market investment conferences, and the recurring theme I hear from foreign investors is how to transfer wealth safely into “the perceived” havens of political stability, often specifically into the United States.
As a result, we see a continued flow of capital into the United States, and real estate in particular is becoming the preferred investment choice for wealth preservation replacing gold as a safe haven. Foreign high net worth individuals are more likely to invest in real estate than in other assets. This is largely due to familiarity and the source of their wealth. For example 28 percent of wealth held by Asian ultra-high net worth individuals (UHNWI, also defined as those with net assets of at least $30 million) is in the real estate industry, compared with 6 percent of wealth held by US UHNWI (Financial Times). The preferred store of wealth today seems to have shifted from gold to “an apartment in Manhattan, an apartment in Vancouver, in London” said Blackrock’s Chairman, Fink (New York Apartments Top Gold as Store of Wealth). As a result, real estate prices in “Crown Jewels” areas in the US such as New York, Miami, and Los Angeles are accelerating and will continue to sky rocket for the foreseeable future and likely defy normal cycles.
Driver 5: The global expansion of increasingly sophisticated foreign institutional investors and financials firms further supports to US real estate growth
Traditionally, the US has dominated financial services with the leading investment, insurance and asset managers domiciled here. That picture has changed. Sovereign funds, insurance firms, investment banks and pension funds from China, the Middle East and Latin America hold trillions of dollars in AUM, are sophisticated in their investment approach and are looking to diversify globally. The US market for them is particularly attractive. Among these investors demand is high for real estate assets such as hotels, land mark properties, and muli-family and commercial properties. For example, recently the Chinese government required Chinese insurance companies to invest 10% of their assets abroad, which led to the acquisition of America’s most famous hotel, the 82-year-old Waldorf Astoria to a Chinese insurer in a record $1.95 billion deal (Forbes).
Other notable deals include:
- Abu Dhabi Investment Authority (ADIA), one of the world’s biggest sovereign wealth funds, is investing alongside the Singapore Sovereign Wealth Fund and Related Companies, the lead developer of Time Warner Center, and have purchased Time Warner’s 1.1 million square feet of space at Columbus Circle, Manhattan, for $1.3 billion. The two foreign investors reportedly own 80 percent of the deal.
- Cindat Capital Management Co., a subsidiary of China Cinda Asset Management, is partnering with Zeller Realty Group in the $304 million purchase of 311 South Wacker Drive, a 65-story, 1.3 million-square-foot Class A office tower at the gateway to Chicago’s West Loop. Cindat owns 70 percent of the venture.
- Shanghai-based Fosun International acquired One Chase Manhattan Plaza in New York from JPMorgan Chase for $725 million late last year. This was the largest purchase of a New York office building by a Chinese investor to date.
And it isn’t just the skyscrapers of Manhattan that foreign investors desire, nor is it just already-built Class A properties. Sophisticated foreign institutional investors are branching out of the gateway cities of New York, Washington and San Francisco in search for higher returns in “the 18 hour city” markets as Seattle, Houston, Chicago, Los Angeles, Atlanta and Denver. Foreign institutional investors are more likely to partner with US real estate fund managers to gain access and local expertise. Total foreign institutional investment in the United States real estate market in 2014 total $40 billion, and most likely this is just the tip of the ice-burg.
Wild Cards that Introduce Risk into the System:
As with every other market I would like to highlight the wild cards and risk that may lead to a reversal. For real estate, the wild cards for better or for worse are firmly placed in the hands of politicians, central bankers and the US courts.
Government and real estate has always been closely intertwined in the United States. To understand why, one needs to look at the very value system of American society and the fundamental American philosophy of home ownership. In America to own a home is a sign of middle class prosperity and embodiment of the American Dream. In other words it is a right of every American to aspire for home ownership and thus, a responsibility for the government to facilitate home ownership. Thus whether most US tax payers are fully aware or not, affordable mortgages at increasingly higher levels of leverage have been and still are subsidized by the government and ultimately with tax payer dollars. If that were not the case, the US housing market would be looking more like the European housing market – two to three times more expensive mortgages, leading to smaller dwellings, longer co-habitation with parents.
Historically, semi private public giants Fannie Mae, Freddie Mac through implicit government guarantees have artificially decreased the cost of borrowing and thus the cost of owning a home. Clearly, after the 2009 melt-down of these institutions among an array of other firms such as AIG, BoA, Lehman, questions were raised whether the cost of supporting the homeownership dream is worth it. That is a question of a different article. It surmises to say that currently, investors, tax payers, hedge fund managers, the US Fed, Congress, the President and the US courts are all at odds what to do next. The outcome of what happens to the two mortgage re-insurers will undoubtedly impact real estate markets. However, the current stalemate, is unlikely to be resolved any time soon.
Translating the Trends into Market Bets:
Below are my views of how the above historic macro and structural trends translate into market bets in US real estate:
- Long commercial and residential real estate in “crown jewel” cities ie Manhattan, Miami, San Francisco supported by inflow of foreign capital which should only intensify overtime.
- Long residential and commercial development in “18 hour city”centers which provide a quality of life baby boomer desire and millennials like to rent in.
- Long multi-family rental properties for Grade A and sub grade A properties. The demand for this sector will be supported the generational shift of boomers and millennials for the next 5 + years.
- Long US REITs which may be due for a correction after the last sell off. Investors need to watch closely the changes in the likelihood for interest rate hikes.
- Short certain suburban areas and houses in the over $ 1 million + range as baby boomers downsize and the next generations cannot afford to upgrade as fast. We may be seeing the end of the American “McMansion” which could be phased out with the boomers. The trend is area specific and understanding of the local factors is important.
- Short retirement or resort like properties in remote areas i.e. some areas in Florida and Arizona – these assets might have been overbuilt and do not align with the boomer preferences for proximity to town centers and their children.
- Long FNMA and FDMC. The expected ROI here is high if the lawsuits end up in favor of investors. But your investment may end up at $0 if the companies are dismantled. This is not a bet for the faint hearted or for those that cannot wait for a resolution, which may take years.
- The above views are solely those of the author and do not represent the views or recommendations of any financial institution or money management firm.
- The above views are not recommendation or solicitation to purchase any securities and investors should trade at their own risk.
- The author holds long positions in FNMA and directly or indirectly holds a number of US real estate investments.