The Effect of the U.S. Housing Market on REITs

This article is republished with permission from REITCafe.

Sales activity and price appreciation for U.S. existing homes are healthy, but builders are reacting cautiously. Limited new construction is keeping supply and demand fundamentals in check, but also affecting sectors of the economy that depend on homebuilding.

Job and wage growth combined with low mortgage rates are fueling the housing market. The nation added 3.1 million jobs in 2014 and another 2.65 million jobs in 2015. Average hourly private sector wage growth started to accelerate during 2015, gaining 2.5 percent for the year. Long-term mortgage interest rates have fallen in recent weeks and remain very low, even after the Federal Reserve raised short-term rates in late 2015. The prospect of higher interest rates has provided impetus to homebuyers to act before rates rise.

Sales of existing homes climbed 11.0 percent in 2015, and the median price for an existing home rose 8.2 percent, according to the National Association of Realtors (NAR). The inventory of unsold homes dropped to 4.0 months in January, the lowest level in many years.

However, the new-home development market is less robust than the resale market. January data for new-home sales released last week by the U.S. Census Bureau showed a 9.2 percent decline from December and a 5.2 percent decrease from year-ago levels. New-home starts dropped 3.8 percent to a 1.1 million annualized rate between December and January, the weakest level in three months. Homebuilder confidence also fell in February to a nine-month low, according to the National Association of Home Builders/Wells Fargo builder sentiment index. Homebuilders expressed concern about factors that could affect production, including rising land and labor costs and labor shortages.

Current housing market conditions have affected both timber and single-family-home real estate investment trusts (REITs). Limited new residential construction, the strong dollar, and concerns about exports to China, which has a slowing economy, have taken a toll on timber REITs. U.S. softwood log exports were down 23 percent during the first nine months of 2015 from year-ago levels, and U.S. lumber shipments to China declined by 5.7 percent for September 2015 from a year earlier. Total returns for timbers REITs during 2016 have measured –14.64 percent, making it one of the worst-performing sectors. Timber REITs are consolidating through merger and acquisition activity; Weyerhaeuser completed its purchase of Plum Creek Timber recently.

Returns for single-family-home REITs are down 15.06 percent, marking the weakest performance of any sector this year. Rising home values have increased the value of their underlying assets, but they make home acquisitions more difficult. Expenses for the REITs are high because costs required to get properties ready to rent are significant, and the sector’s dividend yield of 2.35 percent is the lowest among the various REIT sectors. This sector has also been characterized by merger activity that will help create economies of scale: the newly formed Colony Starwood Homes represents the merger of Starwood Waypoint Residential Trust and Colony American Homes, and American Homes for Rent and American Residential Properties announced a merger in December 2015.

Shopping centers: The 2015 holiday shopping season made it clear that e-commerce is affecting brick-and-mortar retail. Yet, the majority of consumers still make a trip to the grocery store, drugstore, or dry cleaner. Discount retailers, like T.J. Maxx and Ross, which are frequent tenants of these centers, are performing well, too. REITs that focus on grocery-anchored shopping centers are benefiting from this traffic, which has driven shopping center REIT returns of –0.33 percent so far this year.

Data centers: Growth in the amount of stored data and cloud computing, along with a trend toward outsourcing IT infrastructure, has fueled demand for data centers. Leases for data centers are generally long-term, and larger corporate tenants have strong credit ratings. CBRE reports that the construction pipeline in primary markets is significant, but that more than half of the space underway was pre-leased at year-end 2015. Total returns for the sector have come in at –0.50 in 2016.

Manufactured homes: Strong demand for inexpensive housing and aging baby boomers seeking retirement and vacation homes have helped propel manufactured housing into one of the best-performing REIT sectors, with a year-to-date return of –0.87 percent. Rising rents and home prices are causing more people to consider manufactured housing rather than site-built housing. The housing market recovery has also made it more feasible for snowbirds to sell existing homes and to buy manufactured homes in retirement destinations. The market is supply-constrained and fragmented.

Self-storage: Job and population growth, smaller living spaces with less storage, and the propensity for people to acquire and hold onto belongings have driven demand for self-storage. New construction has been limited, resulting in high occupancy levels and strong rent growth. The month-to-month duration of self-storage leases is attractive to investors in the current low-interest-rate environment, because operators can respond quickly to changes in the market. Total returns for the sector amount to –1.60 percent so far this year.

Seemingly few commonalties stand out between this year’s best performers. Some sectors benefit from short-term leases where rents can be adjusted rapidly, while investors are attracted to other sectors with the security and stability of long-term leases. Similarly, a recovering housing market and higher interest rates drive demand for some REITs, while other sectors are hampered by these same trends. Ultimately, business expansion and job growth support widespread demand for all types of real estate, and limitations on available new supply are helping drive rent growth.

* TREPP-i Survey Loan Spreads levels are based on a survey of balance sheet lenders. For more information, visit Trepp.com.

** - 10 yr. Treasury Yield as of 2/26/2016.