S&P's Real Estate Exuberance Looks Irrational
Last month, the overseers of the S&P 500 index split real-estate companies from financial stocks, creating an 11th equity category in response to the growing size and outperformance of the sector in recent years. Investors, though, should ask themselves if this is the property market’s equivalent of shoe-shine boys giving stock tips.
Against a background of record-low interest rates, $62 billion flowed into U.S. real-estate funds from 2001 through 2015, with more than 120 Real Estate Investment Trusts going public and raising more than $38 billion. There are now 240 REITs listed on the NYSE and Nasdaq exchanges, with the real estate sector accounting for 3 percent of the S&P 500’s market capitalization.
Yields on REITs have traditionally exceeded those of the broader S&P 500 index, and leaped as house prices collapsed in the housing crisis a decade ago. The spread between the two yields then was fairly constant for about four years, but in the past two years, the difference has widened in favor of REITs. Investors have warmed to REITs for their ability to generate hard cash here and now, rather than waiting for capital appreciation from the (expensive) wider stock market. The combination of healthy dividends and price recovery means total returns for REITS have surged after bottoming in 2009:
Earlier in the recovery, single-family housing was subdued as many potential new homeowners lacked the credit scores, down payment money and job security to buy. They were also chastened in the aftermath of the price collapse; home ownership plunged as those who did form new households moved into rental apartments instead:
That drove rental vacancy rates down and multi-family housing starts up. About two-thirds of multi-family units are rentals, and building has recovered to reach 420,000 per annum, surpassing the earlier annual norm of about 300,000 starts. But single-family housing starts -- even after rebounding to a 720,000 annual rate from a low of about 400,000 -- are still far below the pre-housing bubble average of more than 1 million.
Even as house prices have recovered, they’ve been outpaced by rising rents. As a share of median income, rents have jumped while mortgage costs have fallen. Consequently, the National Association of Realtors’ Housing Affordability Index, even though it’s down from its March 2012 peak, is still well above its January 2007 nadir:
This index assumes that a household with median income buys a median-priced house with a 30-year fixed-rate mortgage at the prevailing interest rate. So its ups and downs are driven by family incomes, house prices and interest rates.
I broke the index down into its component parts, comparing the January 2007 to March 2012 increase, the March 2012 to June 2016 decline, and the entire lifespan. The earlier rise was fueled equally by declining mortgage rates and falling house prices. The ensuing decline in affordability was due to the leap in house prices, with small offsets from declining mortgage rates and rising income.
Since the start of 2007, the primary driver of the net 46 percent rise in affordability is the decline in mortgage rates. The net rise in house prices subtracted about 19 percent from the index while the small overall decline in incomes reduced affordability by 3 percent.
I also simulated the effect of a one percentage-point increase in mortgage rates to 4.9 percent from the current level of 3.9 percent, assuming home prices and incomes remain steady. Higher borrowing costs would reduce affordability by more than 11 percent. A 1 percent rise in house prices reduces affordability by a bit less than 1 percent, while a 1 percent increase in income adds the same amount. This confirms that housing, a very leveraged investment, is primarily driven by financing costs.
With conditions moving in favor of home ownership and away from rentals, I anticipate a similar shift in housing demand, although residential construction is not likely to grow appreciably. So far this year, investors seem to agree, with a 0.2 percent decline in the apartment REIT sub-index for apartments while the residential single-family component rose 3.5 percent.
There’s market evidence to reinforce this view. In the third quarter, apartment rents fell in San Francisco, New York, Houston and San Jose, the first drops after six years of boom. Nationwide, rent increases slowed for the fourth consecutive quarter, rising 3 percent in the third quarter compared with 5.2 percent in the year-earlier period.
Single-family housing will no doubt attract ample funds from REITs and other sources, now that the bulge of mortgage foreclosures has been eliminated. Also, with fewer households owing more than their homes are worth, more homeowners are able to refinance or purchase new abodes, and fewer will abandon their mortgage commitments.
Despite the bright outlook for REITs and other lenders that concentrate on single-family housing, it’s important to remember that investor zeal for yield has driven money into real estate of all stripes as well as other higher-yielding vehicles such as utility and consumer staple equities, preferred stocks, emerging-market securities and junk-rated bonds.
Many of these investment flows appear overblown, perhaps to the point of irrational exuberance. And note that the guardians of the S&P 500 are not immune to such enthusiasms; recall that in 2001, just after the bursting of the dot com bubble that had exploded the Nasdaq index, they added Information Technology as a subsector.
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