A CLOSER LOOK AT REAL ESTATE: 2018 TRENDS & HEADWINDS - BMO Private Bank
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Jeffrey I. Rogers, Senior Equity Analyst, BMO Wealth Management - U.S.
Michael P. Stritch, CFA, Chief Investment Officer, BMO Wealth Management - U.S.
Monday, April 16, 2018
A CLOSER LOOK AT REAL ESTATE: 2018 TRENDS & HEADWINDS
Over the last 12 months, the S&P 500 has increased over 10%, from 3.1 months in December (revised from 3.2). The low level of
unemployment has decreased to 4.1% from 4.4% while the labor inventory may help new home sales as prospective buyers have
force participation rate has stayed flat around 63%. The economy difficulty finding existing properties for sale. Increased construction
is humming along and with tax rates decreasing, and we are would also help to reduce the undersupply, and high builder
actually seeing small signs of inflation. This economic backdrop confidence should lead to an increase in output going forward.
should benefit the owners of real assets, but given where we
Mortgage rates rising, but still low
are in the cycle, not all tiers of real estate are created equal.
Mortgage rates have also spiked in 2018 (Exhibit #1), though remain at
Will the residential run continue? low levels in a historical context. At 4.34%, rates have increased 0.49%
Single-family existing home sales decreased 3.8% sequentially in from the beginning of the year but still below the 15-year average of
January to 4.76 million homes on a seasonally-adjusted annual basis, 4.78%. Going forward, we expect a gradual rise in mortgage levels
the second consecutive drop after the recent high of 5.05 million homes as inflation and interest rates continue moving higher. It is important
annualized in November. The slowing sales make sense in light of the to note that mortgages are not tied directly to the 10-yr Treasury,
lack of inventory, which started the year at the lowest level on record although there is a correlation between rates. When borrowers take
in terms of the month’s supply of homes for sale. The lack of available out mortgages, the lending institution typically sells those mortgages
inventory and increased competition meant that homes did not to Fannie Mae or Freddie Mac who then bundle the mortgages into
remain on the market long, averaging 42 days in January, consistent bond-like securities for resale on the secondary market. It’s in the
with 40 days in December, and down from 50 days in January 2017. secondary market where mortgage rates are established. As the
economy heats up, mortgage investors demand higher yields. Those
Single-family prices increased 5.7% year-over-year, with increases
higher yields fall onto the lenders who -in response- increase mortgage
of 9.0% in the Midwest, 8.2% in the West, 6.1% in the Northeast,
rates. So, while the trajectory of the 10-year reflects overall sentiment
and 4.7% in the South. These higher prices are good for owners
within the economy (hence the correlation to mortgage rates) it’s
and sellers, but hurt affordability, which we see becoming a more
not the “baseline” rate from where mortgage rates are determined.
significant issue, especially in the West. The share of first-time
buyers slipped to 29% in January, down from 32% in December, What about tax law changes?
and 33% in January 2017. However, we do expect easing credit The state and local tax (SALT) deduction is most heavily used
conditions in 2018 alongside added activity from first-time buyers, by taxpayers in a handful of high-tax states, and is one of the
but the lack of inventory is most acute at the entry level. The supply largest deductions claimed by the top quintile of households by
of existing homes for sale increased to 3.4 months in January, up income. It also costs the federal government about $100B per
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-1- Please see disclosure on last page
Exhibit 1: Pending Home Sales and Mortgage Rates year. Loss of the SALT deduction could result in a tax increases for
the average itemizing taxpayer in many of those locations.
(%)
140 7
The question of “what happens to high-end real estate” in high-
Pending Home Sales Index (LHS)
130 30-Year Mortgage Rates (RHS) 6.5 tax states is a good one, and one that may not have the easiest
of answers. There are two ways to look at this question. The first
120 6
is straight forward and intuitive: Under the $10K deduction cap,
110 5.5 high-end properties in high tax states should go down in value
100 5 because the cost to carry the property has now increased. So that’s
the simple “real estate behaves like bonds” answer. There is a
90 4.5
second option, however, that takes the “tax cuts/SALT deductions”
80 4 as something that could offer a 2nd derivative catalyst for high-end
70 3.5
home prices, as the broader “tax cut” could further stimulate the
Source: National Association of REALTORS®, Bankrate.com, BMO Wealth Management economy. If it’s true that wealthy people grow wealth at a higher
60 3
rate than median income or low income people, then it stands to
reason that in a strong economy those with higher wealth could
shrug off the inconvenience of higher taxes in the area of a limited
SALT deduction as personal net wealth increases at a greater rate.
What about commercial real estate?
Commercial real estate generally falls into the following categories:
Office, Industrial, Self-Storage, Diversified, Lodging/Resorts, Retail,
Exhibit 2: Average Cap Rates by Property Type (%) Residential (or Multifamily), and Health Care. Categories can be further
divided into, for example, Class-A vs. Class-B buildings, regional
Retail Industrial/Warehouse Multi-Family Office
9 malls with national department store anchors, or neighborhood strip
centers with a national chain drugstore as the flagship tenant.
Trends suggest there continues to be strong interest in the commercial
8
real estate (CRE) space. Despite challenges among certain industries,
particularly anything that relates to retail, there is no shortage of
7
dry powder from institutional investors and banks as they look for
the next deal. Part of the problem facing commercial real estate,
is that Cap Rates as shown in Exhibit #2 (simply defined as Net
6 Operating Income (NOI) to property asset value) are compressing
as the demand elevates prices faster than lease/rent rates.
Source: Real Capital Analytics, Bloomberg, BMO Wealth Management
Chart #3037.1 The real estate Long-Term Growth Heat Map prepared by Maximus
5
Advisors (Exhibit #3) shows considerable strength in the Southwest
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and Southeast (save for the tepid mid-Atlantic sub-regions) of the
United States, implying low vacancies, rapidly rising rents, and
demand strongly outpacing new supply. While not as robust, the
West - which includes all of California, Las Vegas, Portland, and Seattle
-2- Please see disclosure on last page
Exhibit 3: Commercial Real Estate Heat Map by Region
Source: BMO Financial Company Reports; Maximus Advisors 12/7/17
– is demonstrating a stable real estate environment with average Conclusion
vacancies, moderate rent growth, and balanced supply and demand. Strong U.S. economic growth is expected to continue for the
More challenged are the Midwest – particularly the rustbelt cities remainder of 2018, which is supportive of housing pricing. Impacts
of Cleveland, Detroit, Chicago, and Milwaukee - and Northeast with of the recent tax changes remain to be seen, however, as capping
high vacancies, considerable supply-side risk, and flat to declining the SALT deduction may adversely impact the overall demand at
rent growth primarily on challenges from Office and Retail. the high-end of the single family residential market. That said,
affordability still favors single family residential over renting.
Not surprisingly, the strongest regions continue to track from coast
to coast through the southern part of the United States. Also not Within Commercial Real Estate (CRE), the continued overall health
surprisingly, Class A, B, and C industrial demand is getting a second and stability of the various CRE markets is likely bolstered by
leg of drivers from e-commerce, cloud computing and legalized investor and lender discipline. This will help mitigate supply/
cannabis to supplement traditional industrial production which is demand imbalances that occur in certain sub-market property
approaching cyclical highs. This suggests opportunity still exists types. The recent change in tax policy has limited direct impact on
across the landscape, but a rising tide may no longer lift all boats. the CRE space, but should serve as an economic tailwind driving
employment and provide an additional leg to support price inflation.
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