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Hawthorn Strategy Insights
Multifamily REITs: Stronger for Longer
This issue of Strategy Insights takes a deep dive into real estate, focusing on the
multifamily industry, and reviews how we believe the asset class is likely to behave.
Real estate may get a bit less attention than the broader equity markets, but it
is certainly no less affected both by secular drivers and the significant changes
occurring in the current market environment.
Introduction
Stephen Hawking once defined intelligence as “the ability to adapt
to change.”1 In today’s market, many investors must adapt to some
particularly large-scale deviations from the so-called “norm”: the Chinese
economy is growing more slowly, the commodity super-cycle has ended,
and the Federal Reserve (Fed) is likely to soon begin the normalization
process with respect to interest rates. Each of these factors individually
has the potential to alter the current investment landscape. But their
combined uncertainty has created an even more complex equation that
has precipitated a rapid increase in market volatility, the likes of which
we have not seen for some time.
There are several links between future real estate performance and
some of the hottest economic and social issues, for example, job growth,
interest rates, demographics, and immigration. As with many asset
classes, multifamily real estate has enjoyed a number of strong years,
driven by a combination of unique attributes. By analyzing each of these
attributes, we may develop a better understanding of what we believe to
be the probable longevity of the current cycle and long-term investment
potential. We believe such analysis is critical when determining how real
estate should fit within an overall asset allocation, both from strategic and
tactical points of view.
Quick Look: Real Estate Investment Trusts
The majority of our discussion will focus on real estate performance in
the context of publicly traded real estate investment trusts (REITs). A REIT
is a trust company that accumulates a pool of money, typically through
an initial public offering, which is then used to buy, develop, manage, and
1
Stephen Hawking, http://www.brainyquote.com/quotes/quotes/s/stephenhaw378304.html.
Fourth-Quarter 2015
Christopher D. Piros, Ph.D, CFA®
Managing Director of
Investment Strategy
215.585.7817
[email protected]
Jeffrey Mills
Investment Strategy and
Portfolio Management
215.585.6820
[email protected]
sell real estate assets. The owner of REIT shares owns a portion of a managed
pool of real estate, which generates income through renting, leasing, and selling
property and distributes it to shareholders on a regular basis.2
Real estate companies elect REIT status primarily because of tax advantages.
REITs are not taxed at the corporate level as long as they comply with a number
of criteria, including distributing 90% of their taxable income to shareholders.
As a result, investors avoid “double taxation” wherein returns are subjected to
two layers of taxes—once at the corporate profit level and once on capital gains
and earned income at the shareholder level. For the companies themselves,
because taxable income includes the effects of depreciation, companies can pay
out 90% of taxable income while still retaining 30-40% of cash flow. This untaxed
cash can then be used typically to fund future growth.3 Along with the benefit of
potential capital appreciation, REITs generally offer attractive, reliable income
streams. In fact, since 1995 REITs have averaged a dividend yield of 5.8% versus
just 1.8% for the S&P 500®. Also, although correlations to equities are on the
rise, REITs still have the added benefit of being a portfolio diversifier.
Current Performance Trends
Absolute and relative REIT performance in 2014 was very strong across all
property types. For the year, the FTSE All Equity REIT Index generated a total
return of 28.0% while the S&P 500 returned 13.7%. Looking at a 20-year history,
REITs have consistently outperformed the S&P 500 while exhibiting only slightly
higher volatility, returning an average of 13.5% per year versus 11.8% for the
S&P 500 (Table 1, page 3). Performance in the multifamily category (FTSE
NAREIT-Equity Apartments) has been even stronger, returning 39.6% in 2014,
with an average annual total return of 14.7% over the same 20-year period.
REITs continued their relative outperformance at the start of 2015; however,
that story started to unwind as investors considered the possibility of the Fed’s
interest rate hike. Just as in 2013 when then-Fed Chairman Ben Bernanke
hinted at a potential tapering of quantitative easing, REITs began to lag earlier
this year as investors viewed rising interest rates as increasingly likely. Higher
interest rates have a direct effect on borrowing costs for new projects, raising
concerns among some investors that REIT revenue growth may slow as projects
are delayed in the face of rising mortgage costs. Interest rates will also affect
the economic cycle. When interest rates are low, the economy has historically
expanded, while higher rates have been associated with tightening conditions
and slower economic growth. As growth slows and borrowing costs rise, the
single-family housing market is often the most vulnerable because affordability
is eroded by decreased purchasing power. This can actually create a more
positive backdrop for the multifamily category as more people are driven into
2
3
Investopedia, “The REIT Way,” http://www.investopedia.com/articles/03/013103.asp..
Ross Smotrich and Linda Tsai, Barclays, U.S. REITs: REITs 101, September 19, 2014.
hawthorn.pnc.com
2
Table 1
Total Return History of REITs
12/29/95
12/31/96
12/31/97
12/31/98
12/31/99
12/29/00
12/31/01
12/31/02
12/31/03
12/31/04
12/30/05
12/29/06
12/31/07
12/31/08
12/31/09
12/31/10
12/30/11
12/31/12
12/31/13
12/31/14
Average
Volatility
FSTE NAREIT
NAREIT Apartments
(All Equity REITs)
(Multifamily)
15.27%
12.26%
35.27
28.93
20.26
16.04
-17.50
-8.77
-4.62
10.72
26.37
35.53
13.93
8.66
3.82
-6.15
37.13
25.49
31.58
34.72
12.16
14.65
35.06
39.95
-15.69
-25.43
-37.73
-25.13
27.99
30.40
27.95
47.04
8.28
15.10
19.70
6.93
2.86
-6.20
28.03
39.62
13.51
20.00
14.72
21.00
S&P 500
37.58
22.96
33.36
28.58
21.04
-9.10
-11.89
-22.10
28.68
10.88
4.91
15.79
5.49
-37.00
26.46
15.06
2.11
16.00
32.39
13.69
11.75
20.00
Source: FactSet Research Systems Inc., Hawthorn
the rental market when purchasing a home becomes cost prohibitive. In fact,
the multifamily market historically has exhibited a modest counter-cyclicality to
the single-family-for-purchase market.4 Also, since many investors view REITs
as an income-generating piece of their portfolios, higher bond yields have the
potential to reduce the attractiveness of REITs relative to many fixed income
opportunities. Chart 1 (page 4) shows that the broader REIT market began to
consistently underperform the S&P 500 in April 2015. However, multifamily
REITs have maintained strong relative outperformance (year-to-date total
return: Apartment REITs down 1.06%; All Equity REITs down 8.9%; S&P 500
down 5.36%).
After such an impressive run, many investors may be wondering if a tactical
exposure to multifamily REITs is still an attractive investment opportunity. Based
on our analysis, the overall fundamentals of multifamily real estate remain
strong, and ultimately performance has historically been more correlated with
4
Ross Smotrich and Linda Tsai, Barclays, U.S. REITs: REITS 101, September 19, 2014.
3
Cyclical Forces: What Is Driving Multifamily
REITs in the Near Term?
Chart 1
2015 Relative Performance
As of September 2015
115
110
105
Index
the health of the economy than the trajectory of
interest rates. That said, valuations are not
overly cheap. Short-term market dislocations
(driven by, for example, a rate hike) could create
an even more compelling value proposition,
in our view. In the analysis that follows, we
take a detailed look at what has been driving
multifamily REITs during this cycle, highlighting
both opportunities and risks. As we discuss in
the valuation section, despite recent
outperformance, we think the multifamily
sector has the underpinnings for more
sustained outperformance.
100
95
90
12/14
1/15
2/15
S&P 500
3/15
4/15
FSTE NAREIT
(All Equity REITs)
5/15
6/15
7/15
NAREIT Apartments
(Multifamily)
8/15
Source: FactSet Research Systems Inc., Hawthorn
To understand what drives performance in this market, we think it is useful
to consider the impact of the following six variables: the economy, the
balance of supply and demand, vacancies, rent growth, homeownership
trends, and interest rate sensitivity.
Chart 2
The Economy
Job Growth Versus NOI Growth Versus Revenue Growth
3,200
The United States continues to exhibit signs
2,200
of stable economic growth, albeit at a slower1,200
than-average pace. In addition to a positive
200
second-quarter GDP revision from 2.3% to 3.7%, (800)
the labor market continues to strengthen, and
(1,800)
multifamily housing fundamentals have an
(2,800)
established relationship to job growth (Chart 2). (3,800)
The logic is fairly simple: as the economy
(4,800)
(5,800)
improves, more jobs are created, which
(6,800)
increases the demand for housing. The
1999
2001
2003
2005
2007
2009
2011
2013
2015
unemployment rate is 5.1%, and the U.S.
Apt Revenue Growth, Y/Y (R)
Job Growth, 000s, Y/Y (L)
Apt NOI Growth, Y/Y (R)
economy has added an average of 212,000 jobs
Source: Barclays Research, Bureau of Labor Statistics, company documents
so far in 2015. The PNC Economics team believes
the current trend in job growth will persist and that the tightening labor
market will lead to an acceleration in wage growth, thereby translating into
declining multifamily rental vacancy rates and a supportive backdrop for real
estate fundamentals. Global commodity prices are at least partially reflective
of generally slower growth, but cheaper energy prices should ultimately
prove stimulative to the economy. Although the United States derives less
than 1% of GDP from exports to China, we think the U.S. economy might,
at the margin, still be negatively and unavoidably affected by a global stock
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4
9%
7%
5%
3%
1%
-1%
-3%
-5%
-7%
-9%
market contagion. However, domestic economic conditions seem solid, and
consumer confidence (that is, spending) should be buoyed as a result of lower
gasoline prices and solid employment gains.
Supply/Demand
For some time, the multifamily category has experienced persistent undersupply.
According to Census Bureau data, multifamily completions averaged more
than 500,000 annually from the 1960s through 1990. Although falling during the
early 1990s, completions still averaged about 300,000 per year prior to 2008.
Completions fell sharply toward 100,000 units after the credit crisis.5 Higher
projected permits and starts are only now translating into the completion levels
needed to support pent-up demand and new household formation, which is
currently about 300,000-400,000 per year.6
Chronic undersupply means that significant overbuilding on a national scale
is unlikely in the very near term; however, there are regional markets where
the level of apartment construction should be monitored closely for potential
oversupply risks.
According to Freddie Mac, multifamily starts and
completions are likely to continue to increase into
2016 (Chart 3). Completions are now above their
30-year average and are expected to stay elevated
for several years.7 Even as higher levels of
multifamily completions begin to hit the market,
the absorption has been strong. Demand in the
second quarter fell short of completions by fewer
than 2,000 units. Given the steady supply of
projected completions in the coming quarters,
supply is likely to outpace demand into 2016.
The wild cards in this scenario are the amount
and pace of pent-up demand that will be released
as the economy and labor market continue to firm,
which we believe will be steady but slow. As such,
we expect the supply/demand imbalance to remain
stable, only having a minor effect on national
vacancy rates in the near to medium term.
Chart 3
Multifamily Housing Completions and Projected Starts
As of September 2015
70.00
35.00
60.00
30.00
50.00
25.00
40.00
20.00
30.00
15.00
20.00
10.00
10.00
5.00
0.00
3/01
0.00
11/02
7/04
3/06
7
3/11
Housing Units Completed, 5 Units or More (thousands) (R)
Source: FactSet Research Systems Inc., Hawthorn
As vacancy rates rise, rent growth tends to slow, and REIT performance
often suffers. Through second-quarter 2015, vacancy rates have ranged from
6
7/09
NAHB Multifamily Housing Market Index, Starts, for Market Rent,
Expectations for Next 6 Months (L)
Vacancy
5
11/07
Ross Smotrich and Linda Tsai, Barclays, U.S. REITs: REITS 101, September 19, 2014.
Aimee LaMontagne Baumiller, PNC Real Estate Market Research, Multi-Family Report: 2Q2015, September 22, 2015.
Freddie Mac, 2015 Multifamily Outlook, February 2015.
53
11/12
7/14
4.2-4.8%, with the 4.5% average tightening 20 basis points (bps) sequentially.8
Also, vacancy rates are falling even with a high number of completed new
builds—a sign of strong underlying demand fundamentals, in our opinion.
Oversupply risk should always be monitored, but key secular forces may also
be serving as a tailwind, helping to support apartment occupancy. As mentioned,
however, vacancy rates are likely to tick slightly higher in the wake of an
increase in multifamily completions. PNC’s Real Estate Market Research
team expects the rate to approach 5.0% by year end but remain below the
historical average of 5.4%. Geographic dispersion is likely in this regard, with
supply-constrained markets on the East and West coasts experiencing a
contraction in vacancy rates through the second quarter.9 Markets with lower
barriers to entry and a higher number of forecasted completions should see the
most significant decreases in occupancy.
Rent Growth
Ultimately, it is important to understand how these dynamics affect rent growth,
a key revenue and earnings driver for REITs. In July 2015, apartment rent growth
hit 5.2%, a level last seen in mid-2011, with rental growth exceeding 10% in six
major markets. July growth was stronger than both year-to-date and secondquarter growth of 5.1%.10 Strong rent growth is typically indicative of persistent
rental demand and should bode well for many REIT project pipelines.
Homeownership Trends
Apartment demand is also being driven by general trends in homeownership.
From the 1960s to the 1990s, 64% appeared to be the equilibrium rate
for homeownership. Throughout the 1990s and early 2000s, however,
homeownership boomed, helped by falling interest rates and easing credit
standards. By 2005, the homeownership rate peaked at 69%, 500 bps above
the long-term average. During this period, apartment operating income and
rental occupancy rates became disconnected from the typical relationships with
job growth and demographics. After the housing bust, homeownership began
reverting back to historical levels, with almost 6 million households returning to
the rental market. Every 1% move in the homeownership rate represents just
over 1 million households, or 2.7% of apartment inventory in the country.11
Equity Residential’s (EQR)12 average tenant age is now 34 years, with more than
15% of their buildings occupied by those 55 and older. As this age cohort grows
and continues to demand urban amenities, homeownership rates will likely
remain under pressure, in our view.
Interest Rate Sensitivity
The relationship between real estate and interest rates certainly deserves
additional attention, especially considering the impact of rate hike speculation
8
9
10
11
12
Aimee LaMontagne Baumiller, PNC Real Estate Market Research, Multi-Family Report: 2Q2015, September 22, 2015.
Ibid.
UBS, U.S. Multifamily REITs: Inside the MSAs – Summer is Hot for Rent Growth, August 17, 2015.
Ross Smotrich and Linda Tsai, Barclays, U.S. REITs: REITS 101, September 19, 2014.
Equity Residential (EQR) owns or has an interest in more than 350 apartment communities in 11 states and the District of Columbia.
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62
on recent REIT performance. History has shown that if interest rates are rising
for the “right” reasons (that is, an improving economy), real estate still performs
quite well. For example, between the last two recessions, the 10-year U.S.
Treasury increased from 3.6% to 5.03% over a five-year period. During that time,
apartment REITs produced an average annual total return of 23%, well in excess
of its 14% historical average.
That said, we do not think investor concerns about rising rates are
completely unfounded. Over the past 20 years, there has been an inverse
relationship between the trajectory of interest rates and apartment REIT
performance. Using a time series of monthly data, regression results
indicate that the linear relationship between the 10-year U.S. Treasury and
apartment REITs is negatively sloping with a fairly high R-squared of 0.68
(that is, the relationship is meaningful). Therefore, we believe it is critical
to fully understand the environment in which rates may be rising. Interest
rate movements are just one input into a much more complex equation
determining the likely strength of multifamily REITs.
The Bottom Line
We believe the overall fundamental landscape for the multifamily category
remains healthy. With five straight years of positive operating income growth,
multifamily has now surpassed the length of the last cycle, 2005 through 2008.
Our view is that the current cycle can extend through at least 2016 due in part to
a robust demand backdrop that is likely to persist. Although supply is increasing,
completions should moderate sometime in 2016. As more evidence, a UBS
survey cites pent-up rental demand from so-called “doubled-up” millennials
(that is, those living at home with parents). Nearly half of those surveyed said
they hope to rent in the next 12 months. Affordability continues to be an obstacle
to millennial homeownership, and a larger rental pool strengthens the pricing
power for multifamily REITs.13
Secular Trends: What Is Likely to Drive Multifamily REITs over the
Long Term?
In our view, regardless of cyclical volatility, multifamily rental market demand
will be supported by a number of key secular forces, including favorable
demographics, increasing diversity, and immigration.
Age
Population demographics in the United States are favorable for rental demand,
with large numbers of people moving into prime rental age categories. Thirtyfive percent of the U.S. population consists of renters. However, the younger
demographic has a significantly higher propensity to rent, with 78% of the
18- to 25-year-old demographic and 66% of the 25- to 29-year-old demographic
13
UBS, “UBS Evidence Lab: U.S. Housing Intentions ‘Doubled Up’ Have One Foot Out the Door,” July 6, 2015.
3
7
typically renting. According to the Census Bureau, in 2015 these two age
categories will be the largest five-year cohorts, not the baby boomers.14
Moreover, related trends such as increasing average marriage age may also be
affecting the buy versus rent decision. In 1950, the average age at first marriage
was 22.8 years for men and 20.3 years for women. Today, those numbers have
risen to 28.2 for men and 26.1 years for women. As the younger generations
postpone the timelines for both marriage and children, the inclination is to rent
for even longer periods of time, a strong positive for multifamily real estate.
Perhaps most interesting in our view is the relationship between age and
employment. Despite the generally slow recovery in employment, the 20- to
34-year-old age group has done comparatively quite well. This group accounts
for 21% of the total U.S. population but experienced one-third of all job losses
in 2008 and 2009. However, during the subsequent recovery, this cohort made
up almost 66% of the new jobs in 2010 and over half in 2011.15 This age group is
almost twice as likely to rent as the general population. When coupled with an
established relationship between multifamily fundamentals and job growth, we
see another clear secular tailwind for apartment rental demand.
At the opposite end of the age spectrum, baby boomers looking to downsize
are also now a significant part of the growing demand for rentals. The Urban
Institute expects the number of renters who are 65 or older to double by 2030.
As this group downsizes, many are opting for the maintenance-free lifestyle of
renting. Many developers are targeting this market by designing projects that
cater to the perceived needs of this group. In combination with strong demand
coming from the millennials, we believe rental apartment demand is on solid
footing.
Population Diversity and Immigration
According to the National Multi-Family Housing Council, an increasingly
ethnically diverse U.S. population will transform the apartment industry. By
2044, ethnic minorities are projected to account for the majority of the U.S.
population, reaching 200 million by 2050. Historically, minorities have been more
likely to rent than own. The Urban Institute predicts 22 million new households
will be formed between 2010 and 2030, with 13 million of these households
likely to rent on the basis that a large percentage of this growth will come from
minorities.16 Also from the study, “over the next 15 years, new renters will
outnumber new homeowners—causing a sustained surge of rental housing
demand.”
Also, the Research Institute for Housing America projects that 32% of new
households formed between 2010 and 2020 will be by immigrants. These new
immigrant households could drive as much as 25% of the growth in renter
households, based on an 84% propensity to rent within the first five years of
entering the country.
14
15
16
Ross Smotrich and Linda Tsai, Barclays, U.S. REITs: REITS 101, September 19, 2014..
Ibid.
National Real Estate Investor, “Urban Institute Predicts Rental Surge Among Millennials, Minorities, Seniors,” July 21, 2015.
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8
Valuation Review
Traditional valuation metrics such as the price/earnings (P/E) ratio and the
price-earnings/growth (PEG) ratio are not as useful for investors interested in
assessing the valuation dynamics of REITs. The primary culprit is depreciation—a
noncash charge that systematically allocates the costs (and commensurately
reduces the value) over time of a capital investment—basically an accounting
catch-all for property, plant, and/or equipment. It is typically a significant line
item of a REIT’s income statement. While capital equipment has a finite useful
lifespan, does eventually deteriorate, and will need to be replaced, real estate/
property tends to be emphasized as a store of value and is generally expected to
appreciate over the long term. Thus, incorporating depreciation can significantly
depress or underestimate the net income or earnings of a REIT, leading to
a potential subsequent underassessment of investment value. As a result, it
is common practice to look at valuation metrics that back out depreciation.
In the following analysis, we examine a number of these valuation metrics:
net operating income (NOI) growth prospects, price-to-adjusted funds from
operations (P/AFFO), AFFO yield spreads, capitalization rates/spreads, net asset
value, and dividend yields.17
Multiple
Second-quarter 2015 marked the fifth consecutive quarter of positive same-store
net operating income (SSNOI) growth and, as a result of the reacceleration in
growth beginning in early 2014, multifamily REITs are now well ahead of the last
cyclical peak both in terms of strength and duration.
Chart 4
According to Lazard Asset Management, “the core
Historical AFFO Multiples for REITs and Multifamily REITs
sectors are projected to post 4.9% NOI growth in
As of September 2015
2015, which in turn, is driving high single-digit
30
earnings and dividend growth.”18 At this
25
rate, Lazard expects growth to outpace the core
Consumer Price Index by more than 300 bps in
20
2015 and 2016. We find this very attractive on
15
both a relative and absolute basis.
10
As shown in Chart 4, on a historical P/AFFO basis,
REITs are trading at more than a two-and-a-half
5
multiple turn premium to their long-term average
0
(19.1 times versus 16.5 times). However, this
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
has backed off sharply since the beginning of
Multifamily AFFO
Multifamily L - T Average
REITs AFFO
this year when the AFFO multiple for the group
Source: FactSet Research Systems Inc., UBS, Hawthorn
peaked at greater than 23 times, with multiple
deterioration largely attributed to the looming threat of higher interest rates.
We think valuations are much more reasonable today, especially considering
17
18
Key terms are defined in the Appendix on page 18.
Lazard Global Real Estate Securities, U.S. Real Estate Indicators Report, July 2015: 2.
9
3
2011
2013
2015
REITs L- T Average
Chart 5
REIT Sector versus S&P 500 Earnings Yield Spread
As of September 2015
700
600
500
400
300
Basis Points
the strong, sustainable earnings growth
prospects over the next couple of years.
With regard to multifamily specifically, the
category is currently trading at only a slight
premium AFFO multiple to REITs overall
(19.8 times versus 19.1 times) and just two
turns above its long-term average multiple
of 17.7 times. We think this implies at least
some modest multiple expansion based purely
on historical relationships, if not room for
more substantial expansion ahead, given the
numerous favorable secular drivers already
highlighted.
200
100
0
-100
-200
-300
-400
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
Basis Points
AFFO vs. S&P 500 Earnings Yield Spread
Average Spread
We shift gears here to consider the relative
attractiveness of REITs to equities and bonds
Source: FactSet Research Systems Inc., UBS, Hawthorn
by examining their AFFO/earnings yield spreads.
We use the S&P 500, 10-year Treasury, and Baa
Corporate Bond Yield as proxies. Mathematically,
Chart 6
the AFFO yield is simply the inverse of the AFFO
REIT Sector versus 10-Year Treasury Yield Spread
multiple discussed in the paragraph above. In
As of September 2015
general, the higher the earnings yield, the
1,100
1,000
cheaper the investment, while the same
900
inverse relationship holds true for low
800
earnings yields–pricier investments. Over time,
700
600
academic research has shown that earnings
500
yield has tended to be one of the better
400
300
indicators for assessing valuation across
200
asset classes. Charts 5 through 8 (pages 10 and
100
11) depict the AFFO yield spreads and their
0
-100
long-term averages for both REITs as a whole
-200
and multifamily more specifically compared
1995
1997
1999
2001
2003
2005
2007
2009
2011
with the S&P 500 and 10-year Treasuries.
Multifamily AFFO vs.10 -Yr Treasury Yield Spread
Average Spread
Both REITs and multifamily clearly look pricey
Source: FactSet Research Systems Inc., UBS, Hawthorn
to us compared with the earnings yield of the
S&P 500—just over 100 bps versus their long-term averages. However, we
think the group looks much more attractive when compared with the 10-year
Treasury, trading at roughly a 100-basis-point discount. Given the surprising
symmetry of these two particular relative metrics, we believe it is a toss-up,
suggesting both REITs and multifamily are likely fairly valued at this stage of
the cycle.
The capitalization rate, often referred to as the cap rate, is the ratio of NOI to a
property’s asset value (Chart 9, page 12). One way to think about the cap rate
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2
10
2013
2015
Chart 7
Multifamily versus S&P 500 Earnings Yield Spread
September 2015
700
600
500
400
Basis Points
300
200
100
0
-100
-200
-300
-400
1995
1997
1999
2001
2003
2005
AFFO vs. S&P 500 Earnings Yield Spread
2007
2009
2011
2013
2015
2013
2015
Average Spread
Source: FactSet Research Systems Inc., Hawthorn
Chart 8
Multifamily versus 10-Year Treasury Yield Spread
As of September 2015
1,100
1,000
900
800
700
Basis Points
intuitively is that it represents the percentage
return an investor would receive on an all-cash
purchase. If cap rates are compressing over
time, it generally means that asset values are
being “bid up” and a market is, therefore,
“heating up.” On a cap rate basis, multifamily
REITs are trading roughly in-line with the
long-term average (approximately a 65-basispoint spread) to the REIT sector overall, which
seems reasonable at this stage of the cycle.
The gap between the average cap rate for the
sector and the 10-year U.S. Treasury has
effectively closed over the course of the
summer, with REITs now sitting on top of their
long-term average spread (287 bps). The
spread remains fairly wide and is nowhere
near the levels reached at the peak of the
prior cycle (Chart 11, page 13). The spread
to Baa/corporate bond yields, however,
shows a slightly less compelling picture
(Chart 10, page 12). Since April, the cap
rate-Baa spread has compressed and
is now trading at a slight discount of 42 bps
to the long-term average. While this
relationship does suggest to us that
REIT valuations have become a bit more
extended recently versus Baa corporate bonds,
neither spread relationship suggests a
dramatically overheating real estate market.
600
500
400
300
200
100
0
-100
-200
1995
1997
1999
2001
2003
2005
2007
On a net asset value (NAV) basis, the REIT
Multifamily AFFO vs.10 -Yr Treasury Yield Spread
sector and the multifamily subcategory are
Source: FactSet Research Systems Inc., Hawthorn
trading in a tight range. Looking at P/NAV over
the last 12 months, both categories are currently priced at a 12% discount to
NAV. Looking forward 12 months, both categories remain in a tight, though
marginally smaller, discount to NAV of 10-11%. We think private market
valuations and record capital inflows remain supportive of net asset values
in the longer term, and we would expect this valuation spread to continue to
shrink. For now, both metrics suggest an attractive entry point for investors
considering an allocation to REITs and, in particular, multifamily.
Let us now consider valuation with respect to dividend yields because REITs
are a yield investment by definition. In Charts 12 and 13 (pages 13 and 14), we
11
3
2009
2011
Average Spread
Turning to relative spreads, when they are
positive and well above long-term averages,
we believe it may be a sign that REITs are
undervalued. As can be seen in Chart 13,
spreads peaked in 2002 and then again in
2008-09. While the spreads for both REITs and
multifamily remain in positive territory, they are
pretty small by historical standards. The
divergence in spreads this year parallels the
recent outperformance of the multifamily
category versus REITs overall. On this metric,
valuations are rising a bit for multifamily and
pulling back for REITs overall. This not only
makes good intuitive sense to us, especially
given the lingering overhang of the Fed and
higher interest rates on REITs more broadly,
but it also reinforces our view that multifamily
should ultimately be able to outgrow this
headwind due to the positive cyclical and
secular tailwinds outlined earlier.
Valuation Wrap-Up
Chart 9
Implied Capitalization Rates
As of September 2015
11
10
Percent
9
8
7
6
5
4
2000
2002
2004
2006
Multifamily REIT Implied Cap Rate
Multifamily REIT L-T Average
2014
Chart 10
Cap Rate versus Baa Bond Yield Spread
As of September 2015
150
100
50
0
-50
-100
-150
-200
-250
2000
2002
2004
2006
Cap Rate vs. Baa Yield Spread
2008
2010
Average Spread
Source: FactSet Research Systems Inc., UBS, Hawthorn
Based on our assessment, we conclude that
multifamily REITs fall somewhere between fairly and attractively valued
depending on which metrics are chosen. On the attractive side, we have
four metrics: NOI growth, AFFO multiples, NAV, and dividend yield spreads.
However, on the fairly valued side, we also have four metrics: AFFO yields,
cap rates, cap rate relative spreads, and absolute dividend yields.
Despite the threat of rising interest rates in the near term, we think the
improving fundamentals in the industry and positive secular dynamics within
multifamily help set the stage for a “stronger for longer” scenario playing out
this cycle. As we examine in the next section, record private equity capital
flows into real estate hard assets and specialty real estate funds should
serve to help provide strong underlying valuation support for the asset class.
hawthorn.pnc.com
2008
2010
2012
Total REIT Implied Cap Rate
REIT Industry Long-term Average
Source: FactSet Research Systems Inc., UBS, Hawthorn
Basis Points
compare the historical absolute dividend yields
for REITs and multifamily, as well as yield
spreads relative to the 10-year Treasury. On an
absolute basis, both REITs and multifamily are
trading 150 bps and 300 bps, respectively, below
their long-term average yields. Yields are still at
respectable levels (in the 3-4% range on average)
but we think do not imply a table-pounding
buying opportunity.
122
2012
2014
Private Real Estate Market
Basis Points
Another way to gain exposure to the real estate sector is through the private
marketplace, whether through a limited partnership investment or a direct
purchase of property. Typically, the minimum amount of capital needed to
invest in the private market is substantially higher and can often be a limiting
factor for some investors, in addition to the fairly lengthy liquidity tie-up, when
compared with publicly traded REITs. Private market allocations also tend to
exhibit less short-term volatility than
Chart 11
publicly traded REIT stocks, which at times
Cap Rate versus 10-Year Treasury Yield Spread
react to equity market-driven forces that may
As of September 2015
or may not reflect a real impact on the underlying
value of the real estate investment. Weighing
600
public versus private real estate investments
525
involves a series of tradeoffs, but we often
450
recommend owning both within the same
375
portfolio.
300
19
20
225
150
75
0
2000
2002
2004
2006
2008
Cap Rate vs.10 -Year Treasury Spread
2010
2012
2014
Average Spread
Source: FactSet Research Systems Inc., UBS, Hawthorn
Chart 12
Historical REIT and Multifamily Dividend Yields
As of September 2015
14
12
10
Percent
From a fund perspective, data reinforce our
view that the current real estate cycle has the
opportunity to be stronger for longer. At the
end of second-quarter 2015, private real estate
funds had $249 billion in uninvested capital
looking for a home in the market.19 This is
the highest level of capital ever available to
fund managers (already up 25% year to date
versus year-end 2014 actual results), and
although valuations may be somewhat elevated,
competition to put this capital to work is likely
to continue to support prices in the private real
estate market for some time. The majority of the
uninvested capital exists in North Americanfocused funds, $132 billion, followed by Europe at
$75 billion. In the first two quarters of this year,
real estate funds raised $61 billion, keeping
2015 on track to surpass last year’s fundraising
total. Where is all the capital coming from? A
recent Preqin investor survey showed pension
funds top the list of potential buyers, representing
34% of the total, followed by real estate fund of
funds managers at 13% and endowments at 9%.
Foundations represented about 5% of the total.20
8
6
4
2
0
1993
1996
Multifamily
1999
2002
Multifamily Average
2005
2008
All REITs
Source: FactSet Research Systems Inc., UBS, Hawthorn
Preqin, Quarterly Update Second Quarter 2015.
Ibid.
13
3
2011
2014
All REITs Average
We think the true test for investors is identifying which managers will have
the ability to add real value over time versus those that have just been the
beneficiaries of a rising tide.
Basis Points (in Hundreds)
Further research into fund type preferences reveals increasing demand for
higher risk strategies. Indicative of a continued search for higher yields,
Preqin’s survey data showed value added and opportunistic funds experienced
larger fund flows compared with the less risky (and, therefore, lower yielding)
core and core-plus strategies, a trend likely to continue, in our opinion. To us,
this is a logical manifestation of yield-seeking behavior driven by both a fairly
valued stock market and the likelihood that interest rates remain below
normal for an extended period of time.
Chart 13
REIT and Multifamily Dividend Yield versus 10-Year
Investment Implications
Treasury Spreads
As of September 2015
We believe real estate is an important asset
12
class that should be included in a strategic
asset allocation, not only for its favorable portfolio
10
diversification merits but also as a key beneficiary
8
of the numerous cyclical and secular tailwinds
6
present in the marketplace today. We think the
4
multifamily category is especially well-positioned
2
in light of its strong overall growth prospects
0
buoyed by positive correlations with improving job
-2
growth, vacancy trends, persistent undersupply
-4
and, ultimately, record levels of rent growth.
1993
2014
1996
1999
2002
2005
2008
2011
Longer term, favorable population demographics
REITs-10-Year Spread
Multifamily-10-Year Spread
should provide a strong, sustainable underlying
Source: ISI, Hawthorn
level of support for the category as well.
Our valuation review suggests that publicly traded REITs, in general, and
multifamily, specifically, are not overextended at this stage of the cycle, but
they are not particularly cheap either. As such, we remain somewhat cautious
with respect to increasing real estate exposure in the very near term, since the
possibility of a Fed rate hike remains at the forefront. Should an increase in
interest rates result in a short-term dislocation or valuation re-set in publicly
traded multifamily REITs, we would be actively looking to put capital to work.
Investment Strategy Views
U.S. economic data have remained resilient, with second-quarter GDP growth
revised up from 2.3% to 3.7%. Based on the data, we believe an imminent
domestic recession is unlikely. However, the investment backdrop reflects
a number of potential headwinds. The pace and trajectory of growth in
China and its impact on the rest of the world are likely to remain important
considerations as we move into 2016. The Fed is clearly looking for more
hawthorn.pnc.com
14
2
stability from the global economy before making a policy change, and investor
speculation regarding monetary policy continues to cast a shadow of uncertainty
across the markets.
Equities
A critical component of our equity outlook is that we do not believe a domestic
recession is likely in the near term. Bear markets typically do not just
appear; rather, they usually materialize in anticipation of a recession (Table 2).
Further, if recent pressure on U.S. stocks proves to have been the start of a
more sustained downtrend, it would be the first bull market in history to end
without a single Fed rate tightening. This does not mean we are overly bullish
on U.S. stocks. We remain somewhat cautious in the near term given elevated
market volatility and the recent severe deterioration in market technicals. We
think underlying fundamentals are strong enough to keep stocks in a general
uptrend as we move into next year, even if returns are likely to be below average.
In a market that we think is fully priced, any investment gains will likely depend
Table 2
Overview of Past Bear Markets
Cycle Peak
Bull Market
Duration (Months)
Decline from
All-time High
Crash of 1929
1929
37
-84%
2
1937 Fed Tightening
1937
22
-74%
Premature tightening
3
Post WWII Crash
1946
48
-54%
Postwar demobilization, recession fears
4
Flash Crash 1962
1961
14
-22%
Cuban Missile Crisis, Flash Crash
5
Tech Crash 1970
1968
73
-29%
Economic overheating, civil unrest
6
Stagflation
1972
29
-43%
OPEC oil embargo
7
Volcker Tightening
1980
31
-19%
Extremely high rates to tame inflation
8
1987 Crash
1987
59
-27%
Program trading, overheating market
9
Tech Bubble
2000
118
-42%
Extreme valuations in tech stocks
10
Global Financial Crisis
2007
55
-51%
Leverage, housing, Lehman Brothers
?
78
N/A
Market Corrections
1
Current (2015) Bull Market
Recession
Commodity
Spike
Aggressive
Fed Tightening
Extreme
Valuations
Commentary
Irrational exuberance
No
No
No
No
Long and slow economic expansion
Source: JPMorgan Asset Management
on companies’ ability to grow earnings. In the absence of additional obvious
catalysts, earnings and guidance will be key. We believe earnings can grow;
however, revenue growth will likely be slow, in part due to the global deflationary
impulse being spurred by slowing global growth (China and other emerging
markets in particular). Our view is that this type of market environment favors
active managers who are able to identify companies that can distinguish
themselves from the pack by, for example, taking market share, maintaining
pricing power, and/or expanding margins, and that are largely insulated from
currency pressures.
Currently, we view stocks as relatively more attractive than bonds. For example,
the current earnings yield spread (calculated as the S&P 500 earnings yield
minus BBB corporate bond yields) is 130 bps, whereas over the past 25 years
3
15
BBB corporate debt has yielded slightly more than the S&P 500, on average.
From a valuation perspective, the current 12-month forward (P/E) ratio for the
S&P 500 is 15.6 times, two multiple points below the 17.4 average bull market
peak P/E ratio since 1961. However, one can point to various other metrics,
some of which make the market look more expensive. From that standpoint, we
believe the stock market leans to the expensive side, and longer-term returns
are likely to be somewhat muted from current price levels. If portfolios are light
on cash (below target levels), we would advise raising cash to be more reflective
of allocation objectives. Doing so will likely allow tactical allocations in the future
to be more opportunistic should more attractive valuations materialize.
From a longer-term perspective, we still believe Japan and Europe offer better
value propositions based on attractive relative valuation, continued monetary
policy accommodation, and potential for faster earnings growth (Table 3).
Bonds
Table 3
Market Comparison
The Fed will likely continue to be the primary
Forward 2015 EPS 2016 EPS Current 10-Year
focus of the broad fixed income market. The
Growth
Growth2
Gvt. Bond Yield
P/E1
markets are still pricing in a shallower overall
Japan
14.1
11.4%
7.3%
0.36%
United States
15.6
4.5%
5.0%
2.16%
rate trajectory than the Fed is projecting, so
Europe
14.3
12.0%
10.0%
0.78% 3
we believe there is a chance the first rate hike
1
(and subsequent path) could catch investors off
Equity indexes used: MSCI Japan, S&P 500, MSCI Europe
2
UBS estimates
guard, resulting in a spike in yields. In this
3
10-year German Bund rate
environment, we favor actively managed fixed
Source: Hawthorn
income strategies as opposed to purely passive
exchange-traded funds or index funds. We think actively managed strategies
should be more nimble in periods of heightened market volatility and better able
to take advantage of potential price-value disconnects that may arise.
We prefer to allow the bond markets to recalibrate to the Fed’s eventual actions,
increasing duration once we feel the market is not spring-loaded for potential
rate volatility. As long-term investors, such risks ultimately reinforce our shortduration stance within client portfolios. Should we begin to see a more sustained
rise in yields, our current positioning would enable us to opportunistically
lengthen duration in order to begin capturing higher yields.
In terms of credit, although spreads have widened significantly over the past
two quarters, we are not convinced that credit is particularly attractive, and the
absolute low level of yields is further reason to be cautious, in our view.
Commodities
Volatility in the oil market has yet to show signs of abating. Energy markets
continue to search for an equilibrium level, but uncertainty surrounding the
interaction of slow global growth (demand) and persistent levels of excess
hawthorn.pnc.com
2
16
supply continues to make it difficult for the market to stabilize. The divergent
forecasts between the U.S. Energy Information Administration (EIA) and the
International Energy Agency (IEA) illustrates the difficulty in predicting prices.
The EIA believes the market will remain oversupplied in 2016 (although less
so than today), keeping commodity prices under pressure, while the IEA thinks
production is likely to decline sharply, leading to a corresponding increase in
demand and a slight production deficit, which should theoretically drive prices
higher.
Our view is more aligned with the EIA, believing that prices remain in this low,
range-bound pattern with risks more skewed to the downside. The pure variable
cost to keep production running for U.S. shale producers has been estimated
around $20 per barrel. If production remains elevated and finite storage begins
to reach capacity, the market could be forced to clear at prices near this cash
break-even level. This is not our forecast, but we believe this outcome is more
likely than a price spike driven by a sudden collapse in production.
Real Estate
As covered in detail above, we believe real estate assets are well positioned to
benefit from a number of cyclical and secular market forces. Specifically, we
believe the multifamily category will be supported by favorable demographic and
homeownership trends, while also being well-positioned in light of the current
economic growth cycle. Valuations are not particularly cheap; however, we do
not believe current price levels to be a meaningful hindrance to performance
over both short- and longer-term investment holding periods. That said, as
with most asset classes, the Fed rate hike remains an important near-term
consideration. We would view any short-term price drop in the publicly
traded REIT market as an opportunity to increase portfolio exposure to the
multifamily category.
With regard to the private real estate market, record levels of capital have
flooded into real estate funds over the last couple of years, reflecting continued
strong investor interest and demand. Yet fund managers have not been able to
keep pace with these flows, with large amounts of cash still waiting to be
deployed. There is some concern over whether or not managers could
overallocate capital to projects with diminishing returns simply to avoid
returning uninvested capital back to their investors—an undesirable outcome for
all parties. We think this backdrop is ultimately supportive of real estate market
prices and valuations to some degree, but it offers a less compelling investment
case for increasing portfolio exposure to private real estate alternatives. We
might add that new commitments to private equity funds are unattractive for the
same reason.
3
17
Appendix
Definitions of Valuation Terms21,22
Net Operating Income (NOI): Net operating income equals all revenue from
the property minus all reasonably necessary operating expenses. Aside from
rent, a property might also generate revenue from parking and service fees,
like vending and laundry machines. Operating expenses are those required
to run and maintain the building and its grounds, such as insurance, property
management fees, utilities, property taxes, repairs, and janitorial fees. NOI is
a before-tax figure; it also excludes principal and interest payments on loans,
capital expenditures, depreciation, and amortization.
Funds from Operations (FFO): A figure used by real estate investment trusts
(REITs) to define the cash flow from their operations. It is calculated by adding
depreciation and amortization expenses to earnings and is sometimes quoted
on a per-share basis.
Adjusted Funds from Operations (AFFO): The AFFO of a REIT, though subject to
varying methods of computation, is generally equal to the trust’s funds from
operations (FFO) with adjustments made for recurring capital expenditures
used to maintain the quality of the REIT’s underlying assets. The calculation
takes in the adjustment to GAAP straight-lining of rent, leasing costs, and
other material factors.
Capitalization Rate (Cap Rate): Capitalization rate is the rate of return on a real
estate investment property based on the income that the property is expected
to generate. The capitalization rate is used to estimate the investor’s potential
return on his or her investment. The capitalization rate of an investment may
be calculated by dividing the investment’s net operating income (NOI) by the
current market value of the property.
Net Asset Value (NAV): Net asset value equals the estimated market value of
a REIT’s total assets (mostly real property) minus the value of all liabilities.
When divided by the number of common shares outstanding, the NAV per
share is a useful guideline for determining the appropriate share price level.
21
22
http://www.investopedia.com/dictionary/.
https://www.reit.com/sites/default/files/media/PDFs/UpdatedInvestorsGuideToREITs.pdf..
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18
Hawthorn Locations:
Baltimore
One East Pratt Street
Baltimore, MD 21202
410.237.5967
Cincinnati
201 East Fifth Street
Cincinnati, OH 45202
513.651.8426
Cleveland
3550 Lander Road
Pepper Pike, OH 44124
216.910.0453
Detroit
755 West Big Beaver Road
Troy, MI 48084
216.910.0453
Naples
Newgate Center
5151 Tamiami Trail N
Naples, FL 34103
Philadelphia
1600 Market Street
Philadelphia, PA 19103
215.585.6425
Pittsburgh
249 Fifth Avenue
Pittsburgh, PA 15222
412.762.2279
Washington, D.C.
800 17th Street NW
Washington, DC 20006
410.237.5967
Wilmington
300 Delaware Avenue
Wilmington, DE 19801
215.585.6425
3
19
Balanced Portfolio
Balanced Portfolio
Asset Allocation
Asset Allocation
Baseline
Tactical
Baseline
Tactical
Private Equity 35%
Stocks
50% Debt 5%
Private
Equities
55%
Stocks 50%
Equities
55%50%
Stocks
Bonds 17.5%
Bonds
12.5%
Bonds
17.5%
Bonds 25%
Bonds 20%
Hedge
Funds 40%
Alternative 20%
Alternative 20%
Cash
7%
Cash
Cash
7% 7%
Cash
Cash
5%5%
Real Estate 20%
Equity
Allocation
Equity
Allocation
Baseline
Baseline
Alternative 25.5%
Alternative
25.5%
Alternative
25.5%
Tactical
Tactical
U.S.
75%
US
6574%
%
74%
U.S.
US 73.5%
US 69%
U.S.
U.S.
70%70%
International
Developed
Developed
International
International
20%
20%
Developed
Developed
Developed
International
International
31%
20%
16%
16%
Emerging
Market
5% 5%
10%
Emerging
Markets
International
Emerging Market 10%
Developed 22%
Emerging Markets 4.5%
Emerging Market 10%
International
Emerging Market 10%
Developed 22%
Emerging Markets 9%
Alternative
Assets
Alternative
Assets
Baseline
Tactical
Tactical
Private Equity 35%
Baseline
Private Equity 35%
Private
Debt 5%
Private Equity
35%
Private Equity 35%
PrivatePrivate
Equity Debt
35% 0%
Private Equity 35%
Real Estate 20%
Real Estate 20%
Real Estate 20%
Real Estate 20%
Hedge
Commodities/
Funds
40%
Real
Assets
Commodities/
20%
Real
Assets
Commodities/
Hedge
Real
Assets 8%
Funds
45%
Commodities/
Real Assets 8%
20%
Hedge Funds 25%
Hedge Funds 37%
Hedge Funds 25%
Real Estate 20%
Fixed Income
Baseline
Fixed
Income
Core
Municipal
100%
Baseline
Core
Municipals
100%
Real Estate 20%
Hedge Funds 37%
Tactical
Core Municipal
40%municipals 60%
Tactical
Short-term
Core Municipal 100%
Private Equity 35%
Private Debt 5%
Hedge
Funds 40%
ShortCore
Termmunicipals 40%
Municipal 60%
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