From Jason Payne, Market News Analyst …
Two big developments have occurred in the world of residential real estate since last week’s update.
The first development supports our general thesis that real estate assets are currently poised to reestablish themselves as premier vehicles for reliably high-yielding investment returns, driven primarily by robust increases in average net rents throughout the next few years.
The second development provides a clue about which residential housing markets may benefit the most from this upcoming season of rent growth and yield improvement.
Read the following sections for a cutting-edge analysis of these notable events, and consider their implications for your own portfolio of real estate investments.
Broad Economic Improvement Bodes Well For U.S. Rent Growth
During the last few days, the U.S. economy has displayed impressive resilience in its burgeoning recovery, despite October’s partial shutdown of the Federal government, and despite the prospect of another near-term budget battle on Capitol Hill.
This broad economic resilience has been demonstrated by a variety of encouraging reports, each of which adds credence to our general thesis for significant rent-driven improvements in domestic real estate investment yields.
The Labor Market Is Beginning To Look Much Better (Part 1) …
According to a recent report from the Department of Labor, U.S. employers added a better-than-expected 203,000 jobs in November, continuing the economy’s solid string of payroll gains and representing the strongest back-to-back gain in payroll figures since February-March 2013.
And as a result of November’s pleasantly surprising employment gains, the national unemployment rate fell from 7.3% to 7.0% during recent weeks, representing its lowest level in five years. Similarly, the U.S. economy has now gained more than 2 million jobs so far this year – its highest rate of job growth since January-November 2005.
We also note that U.S. businesses were responsible for almost 97.0% of the new jobs added last month, including a smattering of especially strong employment gains from transportation, warehousing, healthcare and manufacturing businesses.
(This means that less than 4.0% of November’s impressive payroll improvements were attributed to furloughed government workers, most of whom resumed their jobs last month in the wake of October’s 16-day partial government shutdown.)
Similarly, the average U.S. workweek lengthened modestly in November, from 34.4 hours to 34.5 hours, which indicates that employers are now beginning to require more hours of production from their existing workers – a traditional prelude to the hiring of additional workers.
And the nation’s temporary workforce also increased by 16,000 last month, which traditionally foreshadows the hiring of still more permanent employees.
The Labor Market Is Beginning To Look Much Better (Part 2) …
Then, in a separate report yesterday, the Department of Labor also announced that U.S. job openings in October climbed to their highest level in more than five years, which further illustrates employers’ growing confidence in their prospects for sustainable economic expansion.
Specifically, the number of positions waiting to be filled by U.S. employers increased by 42,000, up to 3.93 million, representing the largest number of available job openings since May 2008.
Wholesale Inventories Are Echoing The Labor Market’s Optimism …
Keeping pace with the labor market’s gains, U.S. distributors boosted their wholesale inventories to the highest levels in two years during October 2013, providing another sign that companies are preparing for a pickup in sales.
Wholesale inventories increased 1.4% in this recent report, the most since October 2011, thereby easing economists’ concern that inventories might slump on the heels of similar strength in recent months.
Domestic Productivity Is Continuing to Accelerate …
And as suggested in last week’s Market News Update, the federal government significantly increased its reading of third quarter GDP last Thursday, up from an already-robust estimate of 2.8% to a much higher annual rate of 3.6%.
Driven by the recent improvements in wholesale inventories, this rate of overall economic growth represents the nation’s strongest pace of GDP improvement since early 2012.
Savvy Real Estate Investors Are Preparing For A “New Normal” …
Now, since U.S. businesses are obviously preparing themselves for better economic times, the Federal Reserve has become significantly more inclined to taper its current “easy money” economic stimulus measures – an unusual phenomenon which bodes very well for U.S. landlords who wish to increase their investment yields by raising rents at their properties.
As thoroughly explained in our recent report about investment yields, savvy real estate investors will be wise to remember that their fundamental investment returns are generated by a combination of two distinct economic factors – price gains and interim income:
Price Gains = The difference between an asset’s purchase price and its sale price
Interim Income = The income generated by an asset throughout its holding period
Also, as we predicted in this recent report, the feds are now likely to manufacture a season of artificially stabilized real estate prices during the next few years, while Washington begins to guide our nation toward a healthier brand of broad-based GDP improvement.
And although this return to “normal” real estate price growth will be admittedly artificial at first – due largely to rising mortgage rates in conjunction with tapered economic stimulus measures – the near-term stabilization of U.S. property values should look very similar to our industry’s historical model for traditional real estate fundamentals.
Indeed, under the traditional model for real estate investing (which excludes worldwide financial meltdowns and government-sponsored economic stimuli), modest improvements in property values are supplemented by high amounts of interim rental income …
… which traditionally allows real estate assets to serve as premier vehicles for reliably high-yielding investment returns.
Now, as the U.S. economic recovery is beginning to demonstrate new measures of resilience during recent weeks, keen observers can already identify the onset of this “new normal” for real estate investors.
For example, upon the Labor Department’s recent release of November employment data, U.S. mortgage rates jumped to their highest levels since September 2013, as investors speculated that the Federal Reserve will now accelerate its tapering of recent economic stimulus measures.
To wit, one third of economists surveyed by Bloomberg now believe the Federal Reserve will commence tapering during the next few days, and the percentage of economists predicting a commencement in March 2014 has now declined to less than half.
Simultaneously, the average interest rate for a 30-year fixed mortgage jumped to 4.46% last week, up almost 30 basis points from just a few weeks ago (and up approximately 110 basis points from last November).
These and other economic factors should continue to put downward pressure on near-term property values, causing real estate prices to remain relatively range bound throughout the foreseeable future of America’s ongoing economic recovery.
And although Zillow has not yet released its latest measurements of residential home prices and rents, the following illustration of historical investment yields suggests that the U.S. housing market will soon need to rely on a new wave of rent growth (delightfully aligned with the U.S. economy’s new wave of broad-based GDP growth), in order to maintain its normal spread between residential investment returns and long-term borrowing costs:
Yes, as illustrated by the dotted blue line above, rising mortgage rates are once again threatening to eliminate the spread between investment yields and borrowing costs for investors in the U.S. housing market.
And since savvy real estate investors will always demand a premium return for the risks they assume with each transaction in a "normal" ecomomic environment, you can expect them to soon begin using rent growth as their preferred means for achieving this objective. After all, their tenants are now enjoying access to better jobs (provided by higher-earning employers), and rising mortgage rates are hampering price growth for their happily-occupied properties.
“But where will these fundamental changes begin to materialize first?” you may be wondering.
“As a savvy real estate investor, which markets should I be exploiting right now, in order to best capitalize on this burgeoning transition to the ‘new normal’”?
Ah! Great questions!
(I’m so glad you asked!)
Lucky for us, last week’s spate of encouraging economic reports was accompanied by an important corporate announcement, which provides a fascinating geographical clue in our search for rent-driven yield growth …
M&A Chatter Reveals West Coast Gold Mine
In addition to the recent influx of positive economic data, many real estate investors were glued to their newsfeeds last Friday as a flurry of headlines described a renewed wave of M&A chatter regarding BRE Properties – a real estate investment trust (REIT) specializing in the ownership and operation of west coast apartment buildings.
BRE made headlines earlier this year when it rebuffed an attempted acquisition by Land & Buildings – an east coast investment firm focused on real estate securities. But that initial episode was only the beginning of what is turning out to be a prolonged clash of the residential housing titans.
Indeed, BRE’s rejection of this initial overture has not diminished the interest of its spurned suitor, who continues to publicly lobby the apartment REIT’s board of directors for further consideration of the offer.
And now the nation’s fifth largest publicly-traded apartment landlord seems to have caught the eye of yet another interested buyer.
Specifically, BRE received an unsolicited (and undesired?) $5 billion bid last Friday from Essex Properties Trust – a virtually identical REIT that also specializes in west coast apartment buildings.
And although it is impossible to know exactly how the corporate drama will unfold (sorry shareholders), all this housing-related M&A chatter begs the following question…
“What the heck is going on in those west coast housing markets to make them so darn desireable for institutional investors?!”
Of course, corporate mergers and acquisitions can be motivated by a variety of factors, even within the relatively staid realm of real estate investing. And based on the heated rhetoric between BRE and its potential suitors, this corporate love triangle has its own fair share of unusual considerations.
But $5 billion is still a lot of money to offer for somebody’s portfolio of residential properties, regardless of whatever intangible considerations may be involved.
(At least we think it is!)
So we began to do some fundamental research on BRE’s west coast housing markets, to see if we could better understand the relative attractiveness of this particular landlord’s concentrated portfolio.
And we continue to be amazed by what we discovered.
Most West Coast Housing Markets Are Poised For Superior Rent Growth …
In the initial phase of our analysis, we identified BRE’s largest geographic concentrations of apartment properties, and then we measured each market’s rental yields against the national average for residential real estate.
Since BRE’s portfolio is largely concentrated in only five west coast markets, it was easy to analyze the company’s relative yield profile with the following chart:
As illustrated by the dotted lines above, each of BRE’s major west coast markets is currently yielding much less than the national average for residential housing assets (4.6%). And all but one of these markets has been underperforming the national average throughout the last three years.
That’s right, folks. BRE’s highly desirable west coast portfolio is concentrated in some of the nation’s lowest-yielding residential markets.
Intrigued?
(So were we.)
With this in mind, we then proceeded to rank each of the nation’s top 164 housing markets by their current rental yields, to see if any other west coast metros might also be lagging their peer markets from other parts of the country.
And the results were staggering …
As illustrated in the chart below, the west coast currently includes 25 of the nation’s 30 lowest-yielding housing markets.
Additionally, each of the 15 lowest-yielding "bottom feeder" markets is exclusively west coast in nature – extending all the way from northern Washington down to southern California, and even into parts of western Arizona:
Yes, something is definitely going on with all these west coast housing markets. But it’s not what you might expect …
Rather than boasting the nation’s highest current yields for residential housing investors, the west coast instead boasts the nation's highest expected yields – driven by aggressive institutional estimates for above average rent growth.
You see, coastal property markets are notoriously supply-constrained, because seaside developers are unable to accommodate new tenants by building additional real estate in the ocean. This geographical constraint causes occupancy rates for "land-locked" coastal markets to increase relatively quickly during times of economic growth (such as now). And once a market’s occupancy rate hits its ceiling, rents begin to rise.
In fact, a little extra research from our friends at Axiometrics revealed that west coast housing markets are quickly emerging as the nation’s top performers for both occupancy and rent growth.
And as discussed earlier, this trend is poised to continue throughout the foreseeable future, as the real estate industry continues to regain its basic fundamental health, and as the broader U.S. economy is gradually weaned off its current diet of economic stimulus policies.
So don’t let those institutional behemoths have all the fun...
If you’re a flexible real estate investor looking to capitalize on our industry’s transition into the “new normal” economy, get some feet on the ground in a reasonably-priced west coast market, and start raising rents!
Jason Payne’s next Market News Update is scheduled for Wednesday, Dec. 18th.