In the first half of 2018, the real estate sector had modest returns, trailing the returns of the S&P 500. Fundamentals remain strong along with liquidity, and we see no imminent sign of downturn for the remainder of 2018.
- Occupancies generally remain high
- Demand for rental property generally remains high, outpacing supply and driving rental prices and income higher
- According to the 2018 Preqin Global Real Estate Report, a record amount of dry powder remains, providing a floor for cap rates and prices
- Ample supply of debt and equity capital remain with no sign of deals seizing up or downturn
Despite our optimism, there are a few potential headwinds that we are watching:
- Equity REITs have traded at a discount to NAV, prompting mergers and acquisitions as well as consolidation activity, which could add pressure to buy back stocks and dispose of properties to bolster share prices
- Strong debt liquidity allowing for refinance could push transaction volumes down to a point that puts further pressure on cap rates
- Rising labor costs, fewer skilled laborers, and tariffs on steel could negatively impact construction costs
- Higher interest rates will likely serve to whittle down some of the income component to returns as the Fed continues to gradually raise rates, driving the potential for some investors to tactically shift to riskier assets in order to maintain yields
Source: Real Capital Analytics. Data through March 31 2018.
Despite the pressures of a maturing cycle and some mounting headwinds, we see returns in the real estate sector remaining strong for the balance of 2018 and likely through the first half of 2019. We believe that healthy balance sheets and fundamentals are likely to keep assets performing solidly in the near-term. However, rising construction costs due to tariffs, coupled with continued Fed rate hikes could begin to temper some of the income generated. For the remainder of 2018, high quality income generation remains the primary contributor to real estate returns and we expect overall returns to be on pace with that of 2017.
At a sector level, whether the headwinds represent a mere shift to less robust returns or an actual downturn, we are anticipating a much softer landing to the end of this cycle than prior cycles. Practically speaking, as this cycle has matured it has been met with more stringent underwriting standards, more conservative use of leverage and a more defensive posture by portfolio managers. And unless standards fall, which we think is unlikely to happen at a pandemic level as it did in earlier cycles, we see little risk that residential or commercial property will overheat in 2018 or cause a flashpoint decline. The outlook at this point is more positive than prior cycles and we believe the fundamentals are supporting a smoother ride for real estate investors, even as the current cycle shows signs of waning.
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.
Senior Vice President, Investment Strategy
Boyd Watterson Asset Management, LLC