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Transcript
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 hawthorn.pnc.com 2 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. hawthorn.pnc.com 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. hawthorn.pnc.com 2 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 hawthorn.pnc.com 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.. hawthorn.pnc.com 2 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% The PNC Financial Services Group, Inc. 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