Research Insights, December 18, 2017

One Foot on the Brake, One Foot on the Gas

2017 in Review

It’s been an interesting year to say the least, as politics and the macro economy have created elevated levels of interest and uncertainty.  The new administration was met with yet another anemic first quarter GDP, followed by a second quarter which saw consumers coming out of hibernation to resume consumption.  This new activity added 224 basis points to second quarter GDP, while change in inventories went from detracting nearly 150 bps in first quarter GDP to a net positive in the second quarter.  Third quarter GDP benefitted from businesses stockpiling inventory, adding 80 basis points to the measure as the economy benefitted from increasingly confident businesses with visions of corporate tax cuts dancing in their heads. 

Global GDP growth accelerated in Europe, Japan and Emerging markets providing a synchronous global economic environment which previously had not been seen this cycle providing momentum heading into 2018. 

U.S. Employment growth remained positive but continued to decelerate, and it now stands well below 2014 peak growth levels. This is a natural development that reflects the improving health of the labor market and the increasing difficulty in finding qualified candidates to fill jobs.  

While the industrial sector continues to outperform all other sectors, we are carefully monitoring the deceleration in office-using employment that began in the second half of 2017, as it is a key driver of office space demand.  

On the fiscal policy front, the sting from the failure to repeal the Affordable Care Act seems to be the impetus that is uniting Republicans around tax reform.  The prospect of a significant reduction in corporate tax rates contributed to an  interesting development this year -- the unsustainable combination of skyrocketing equity valuations in the face of low Treasury yields. On the other hand, commercial real estate valuations increased during the year at a much less frenzied pace.

While equity investors were reacting to the prospect of a tax-driven increase in corporate earnings, fixed income investors were reacting to anemic inflation – described by the Chair of the Federal Reserve as “a mystery”.  Low inflation has led to subdued Treasury rates and this, in turn, has resulted in a continuation of the favorable spreads between Treasury rates and commercial real estate cap rates.

Property fundamentals have been varied across property types. While industrial fundamentals remained firm, increasing multifamily housing supply buffeted multifamily housing fundamentals, moderating employment growth and increased supply exerted downward pressure on the office sector, and in retail, it’s a story of the haves and have-nots. Retailers offering branded items at discount pricing in limited assortment that is more difficult to migrate online such as TJ Maxx, Marshalls, and Ross continue to perform well, while retailers selling undifferentiated goods at full price – and are consequently more heavily impacted by online competition - continue to underperform.  While investors maintained a healthy appetite for high quality real estate assets, reduced sales activity reflected the confluence of increasing selectivity and reduced availability, resulting in the strange blend of reduced acquisition activity and moderate price appreciation.

2018 Outlook

Economic Base Case

We think 2018 will be another year filled with deviations from consensus forecasts and an economic environment equivalent to “one foot on the brake and one foot on the gas which is never good for a car, economy or financial markets. Fiscal policy, primarily tax reform, may place a foot on the gas, while the Fed will continue to increasingly apply the monetary brakes.  While tax reform is looking increasingly inevitable, the promised economic gains are not.  

There may be short-term economic gains if tax reform is passed, but the promised impact on employment will likely be disappointing even if there is a material uptick in labor demand, as tight labor markets in many sectors make finding qualified candidates increasingly difficult. If the promised uptick in labor demand does materialize, this would provide a welcome tailwind to what has been underwhelming wage growth relative to most labor market indicators. Considering the amount of cash that many corporations already have on hand, it is also likely that the promised acceleration in business investment will be overshadowed by some combination of an increase in dividends, share buybacks, and debt paydowns.  Collectively, this paints a picture where equity price gains outstrip actual economic gains, providing a sugar high for equity markets, with only moderate economic growth and inflation.  This would place the Fed in the difficult position of having to reconcile additional increases in equity valuations with what may very well be sub-2% inflation.  Add to this a new captain of the Fed along with an already flattening yield curve, and the 2018 economic environment becomes increasingly uncertain.   

Economic Downside

Outside of the base case, known economic and financial market risks are not hard to find.  These include: 

• A surprising material acceleration in the pace of Fed policy tightening and accelerated yield curve flattening;
• Overly aggressive government policies involving trade or immigration that could dampen economic growth and increasing inflation;
• Instability overseas involving the Middle East, North Korea, and the ongoing Brexit negotiations as well as political uncertainty in Washington, DC;
• China’s economy continues to be addicted to credit and a banking system whose financial health remains an ongoing question;
• Elevated equity valuations faltering in the face of earnings disappointments.

What may be the most concerning threat also seems to be the most largely overlooked:  The combination of record high-yield debt issuance and the proposed reduction of interest deductibility.  A massive run-up in debt combined with a significant reduction in an associated tax advantage has the potential to create a disruption in the high-yield debt market (and potentially beyond), depending on the magnitude of the disruption.         

Property Fundamentals

Industrial property fundamentals will continue to be the shining star in 2018 but will also see a degree of moderation from unsustainably strong rent growth and vacancy rates experienced in 2017.  We anticipate a slowing of multifamily housing supply over the next 24 months as construction lenders continue to reign in multifamily construction lending. This is likely to benefit multifamily housing property fundamentals with significant variations in the speed of improvement from one market to the next, as well as between submarkets. Office fundamentals should continue to moderate in response to moderating office-using employment growth and increasing supply.  While retail will remain under pressure from e-commerce, there will continue to be well-located or configured centers that benefit from exceptional trade areas with successful retail segments such as off-price discounters and those that command the superior strategic location within a trade area.

Capital Markets

Some investors will favor commercial real estate for its ability to perform well in an inflationary environment.  Others will focus on the ability of the asset class to benefit from increasing economic growth and the resulting increasing demand for space.  Investors may also continue to place a premium on the relatively stable and high income yields that real estate contributes in a low yield environment.  Still others will value the diversification that real estate contributes to a multi-asset class portfolio.  

Downside risks includes a significant and sustained decline in equity valuations, financial instability events, or a drop off in foreign capital felt first in gateway markets and subsequently felt in non-gateway markets as investors previously priced out of gateway markets migrate back to these MSAs. 

2018 Investment Strategies

Given political and monetary policy uncertainty, downside risks to our economic outlook, moderating property fundamentals, and elevated asset valuations, we are very comfortable with the balanced nature of our portfolios.  

Core fund strategies should focus on current income return and reduced dependence on outsized appreciation gains, as durable and growing income streams will remain a primary goal, with an emphasis on an overweight to assets that have longer terms leases to higher credit tenants, and to markets with elevated tech concentration levels. Opportunities will also be available in the larger most dynamic secondary markets providing both industry diversification and a source of higher current income yields.  The key however is not to chase yield into small markets with limited economic drivers.  

We continue to overweight industrial assets and will begin a gradual increase in return to our multifamily housing weighting, creating a core position that benefits from improved property fundamentals in 2019 and 2020.  In office, our strategy of increasing weighted average lease term and credit quality, and locking in healthy contractual rent escalations is paying off, but at this stage, we expect to moderate our office exposure over the next 24 months.  We will maintain a sector neutral weighting to retail, maintaining our highly selective focus on top tier trade areas, centers commanding the superior strategic location within each trade area, and anchor tenants that both continue to perform well in today’s highly competitive and ever-evolving retail environment.  

In the value-fund space there is a spectrum of strategies that can be undertaken ranging from deep value strategies with an outsized dependence on appreciation to mixed value-add strategies that rely less on outsized appreciation returns as a result of greater income return contributions to total returns.  We will continue to prioritize mixed value-add strategies over deep value strategies.   

Commercial real estate remains uniquely positioned to weather this type of uncertainty due to its hybrid nature that offers both an equity element that would benefit from accelerating economic growth and an income component that would support returns in the event of disappointing economic growth. Add to this equity valuations that have run-up significantly in 2017 and fixed income yields which are vulnerable in the event of unanticipated rates of inflation and commercial real estate should maintain its status as a valuable strategic contributor within multi-asset class portfolios.  Absent a realization of one or some combination of the known risks previously outlined, real estate investor confidence will continue to support asset class values in 2018 while continuing economic growth will support demand for commercial real estate.