RealTMOR Asset Mgmt LLC and RealTMOR Apartment Mgmt LLP
Globally, the US residential real estate market is the most dynamic, deep, transparent and efficient real estate market. Participation in this market is a MUST, for HNI real estate portfolios. Long-term it is one of the best wealth generators and store of value, if elementary mistakes are avoided. However, it is NOT a monolith but is a combination of micro-markets. RealTMOR classifies, Tier 1 cities as New York City, San Francisco, Los Angeles and Chicago, Tier 2 cities as Boston, Miami, Atlanta, Denver and Seattle and Tier 3 cities as Las Vegas, Tampa, Phoenix, San Diego and Charlotte. This for illustration only and not comprehensive, also others may disagree. The key point is that Tier 1 cities exhibit “safer” downward price risk and provide returns through higher capital gains but lower yields. Tier 3 cities exhibit high price volatility and pricing would be seriously negatively impacted during a market downturn. Ensuring an adequate and high-enough yield is the key for Tier 3 city investments. Tier 2 cities fall somewhat midway between these two.
Local factors should be considered before committing to residential real estate in New York or Miami or Seattle or Des Moines. Each of these provide exposure to US real estate but in different ways.
Current State:
Despite positive aspects of the US residential market and the relative positive outlook for the US economy versus other regions, WHAT IS THE CURRENT OUTLOOK? I believe, we are NOT at the end of the bull-phase of the US real estate cycle. However, the current situation exhibits headwinds which could remain till the end of 2019. All through 2018, the US real estate markets faced significant challenges–both nationally and locally. The major challenges through 2018 were affordability risk, price gains being too high and too quick relative to income increases, and Fed induced interest rate hikes risk. Based on the Fed’s recent statements, it seems rate-hike risk may have abated, for now, which would provide relief to increasing mortgage rate risk. The biggest risk at this time is price increases and low affordability, nationally and locally.
Various markets started experiencing upward price moves from 2012/2013. The annual price moves from 2012 to 2015 were strong, but understandable, because from 2007 till 2012 the markets had seen significant price erosion and prices had “bottomed”. From 2010-2012, foreclosures were being addressed, leverage ratios and credit standards were improving, mortgage rates were low and the overall health of the market was improving. Further, the economy was expanding after the global financial crisis, from a few years ago, and employment numbers were gaining. All that created a significant positive outlook for US residential real estate. But prices rose rapidly and, nationally, real estate prices increased 45%+ from 2012 to 2018. This created and exacerbated an affordability problem from 2017 onwards. Investor returns were much higher (from 2012-2018) nationally, as the annual rental yield averaged 4%+. Considering, annual inflation was under 1% and mortgage rates were at historic lows till 2017, returns and price increases were above long-term mean returns. Price increases outpacing wage gains, even in the environment of low unemployment, creates significant affordability pressure. Additionally, the increasing interest rate environment in 2018 made this problem more acute. Nationally, this is evidenced by decreasing/flat prices and softening of non-pricing metrics since Q2 2018. Months’ supply was tight all through 2017 and beginning of 2018 and averaged 5 months but in H2 2018 and 2019 it has averaged over 6. Existing home sales have decreased about 11% from Dec 2017 to Jan 2019. All regions of the country have demonstrated decreasing seasonally adjusted housing starts from end of 2017 to now. Nationally, it seems price growth would be a challenge, probably warranted, for the next 12 months+/-. There is a chance of a price correction over the next 12 months+/-, which could actually be healthy longer term. Currently, it doesn’t seem there would be a repeat of 2006-2008 crash. Properties are staying on market longer, sellers have to take larger and more frequent price cuts from listing prices and multiple bids are not forthcoming. These are the dynamics of so-called previously “hot markets”, such as NYC, San Francisco or Seattle. Possibly sellers are optimistic in terms of list price due to the experiences of the past few years and the cuts lead to realistic ask prices. The strengthening dollar could have a detrimental effect on foreign buyer demand in NY and SF, in particular, and other areas, in general. At local levels, many markets are experiencing dynamics that are an accentuation of the national trend.
New York: NYC real estate was among the first to experience the national trends. It faces an additional obstacle from the Tax Cuts and Jobs Act of 2017. There are new restrictions, federally, on amounts of state and local tax deductions, SALT deductions. This makes property ownership more expensive in high tax areas like NYC, NJ, and CA etc. This creates further detrimental prices effects. The huge employer base in New York and New Jersey (Wall Street, Pharmaceuticals and Media etc) creates significant demand. But purchase price is “still” key and pace of price growth/affordability is a factor, even in NYC.
Miami: There has been a classic case of over-supply of “water-front luxury” condominium developments. Clearing of this inventory will take either a longer than normal period or will necessitate a price adjustment downwards. Many sources report that Miami has almost 24+ months of supply available for sale. Weak economies in Latin America/ Russia etc could have a dampening effect because foreign buyers are an important source of demand.
California / Pacific Northwest: The mammoth bull market in technology stocks and the strength of the IPO market/ funding boom of start-ups has positively impacted real estate prices. Potentially, a slowdown in the global economy, government regulations/restrictions on technology companies and investor fatigue for IPOs/ private funding will exacerbate the current flattening price dynamics of west coast (CA) real estate. Cities in the pacific-northwest have a smaller employer base than CA or NY or MA and are overly dependent on technology companies (e.g. Amazon). Expansion of operations outside of the area to other economic centers in the country results in decreased local job creation. Hence, real estate prices there could face some headwinds. Seattle is a prime example of over-dependence on Amazon and a handful of other “large” employers. Past price gains and “bidding wars”, could be attributable to Amazon’s rise and its job creation capacity. Now, Seattle is facing a bigger slowdown than other markets because affordability is a HUGE ISSUE. Prices in Seattle have dropped 6% +/- from Jun to Dec 2018 and analyzing non-price statistics, there could be more pain ahead. It was the worst performing major US cities. The smaller employment base in Seattle, compared to San Francisco, creates a bigger affordability risk issue. Other effects could be lesser opportunities for people to access higher paying opportunities and lower job mobility, also bigger risk of job losses. Portland and Denver could be in similar situations.
Texas Cities: Texas has seen an unprecedented growth in prices since the start of the current bull market. A large part of this increase could be attributed to the shale oil boom. Any softening of oil prices or increased environmental concerns related to fossil fuels could affect Texas real estate. It’s important to bear in mind that the previous bull market from 2000-2006 largely bypassed Texas.
Multiple Tier 3 Cities: This scenario is common across multiple cities such as Tampa, Phoenix, and Las Vegas etc. Most sellers have set asking price which is their “wish-price” and nowhere close to reality. The unlevered cap rates being marketed are 6%-7% but factor leverage, even conservatively, and cap rates plummet. Comparable sales from 6-months ago, demonstrate that these asking prices are wildly high (20%-40% premiums). Buying at such levels and at such low yields in Tier 3 markets is highly risky.
One can illustrate many such examples, but it suffices to say that being watchful at this time is important. Focusing on making a purchase only if the PRICE IS RIGHT or a Good Yield is available, is the preferred option for the next 12 months or so. In my opinion, over the long-term, US real estate will be a strong wealth creator and should be a focus for any real estate investor. Regarding sale dynamics, one would be advised to understand the risk one is willing to take on, by selling or holding on, and the amount of gains one is comfortable with.