As we are nearing the end of 2018, I thought it would be a good time to reflect on the year, as well as provide some insights into our views of the market.
This past year has been an interesting environment in which to invest. The equity markets have set new highs, only to retreat, giving back all of the gains made in 2018. The bond sector has been challenged by what appears to be the end of the bull market on bonds that has lasted for several decades. Real estate has certainly recovered nicely from the depths of the Great Recession, but requires great skill and discipline to navigate the choppy waters we see.
We are regularly receiving articles and being asked if the real estate market is in another bubble similar to 2008. The answer from our perspective is, “Not as we see the current market”. Although prices are high (low cap rates have persisted), there appears to be a good overall value proposition. That isn’t to say that select markets or asset types aren’t overpriced, but there still remains an opportunity to deploy capital. Generally speaking the real estate market is not over supplied. For various reasons, the industry has exhibited greater restraint than in prior cycles and has to date avoided oversaturating the market. Again there are some specific markets that are experiencing excess supply, primarily in the multifamily arena, but these have only served to reduce rent growth. We aren’t seeing rental rates dropping even in most of those markets with significant supply.
The real estate market has been driven by solid metrics in the economy. We are at historically low unemployment. The economy continues to be performing well, with this period of economic growth being one of the longest in US history. Although there is clearly a recession on the horizon, as there is always one in our future, we don’t believe it will occur for another couple of years. Nevertheless, we do expect that to transpire during the holding period of some of the real estate we are acquiring and have adjusted our underwriting accordingly. This level of conservativism leads us to purchase less assets than we might like, but it provides us a sense of comfort that the acquisitions being made will weather the possible storm and potentially produce the results we are looking for with our real estate assets.
One of the areas where we still see significant opportunity is in the single family housing business. We continue to seek prospects to create new development projects for area homebuilders. The market remains undersupplied, although we have seen some impact on demand due to increased pricing, higher interest rates and the new tax bill. We have focused many of our recent acquisitions on housing that will be affordable, by local standards. One feature that we have targeted is to deliver entitled land to builders at a price point that will support the requirements of FHA mortgages. This allows buyers to qualify with lower FICO scores and they are only required to put down 3%. This expands the buyer pool for the homebuilder, hence providing us greater liquidity when we are ready to sell our land holdings.
Part of the reason why the economic recovery has been so weak, compared to prior cycles, is the lack of recovery in the single-family housing business. According to the Linneman Report1, there remains a $2.3 trillion gap in the GPD, due to slow recovery of the housing industry. This has been due to a number of factors, but the primary one has been a slowdown of household formation. The number of 18-34 year olds now living with their parents has risen from less than 26% to in excess of 32%1. We will continue to monitor this trend to see if this is the new normal or we will return to the historic trend line at some point.
The tax cut has provided significant economic stimulus and although there are reports of a slowing of the impact 1, we believe this impact will continue for some time. We believe this will lead to continued growth of GDP which will allow us an opportunity to place additional capital in select real estate assets.
Although we are moderately bullish, we maintain cautious in our investment decisions. In several cases lately, we have structured our transactions to give up some upside in order to get downside protection and potentially mitigate risk. One of the other ways we manage risk is by harvesting assets where we have completed our value-add strategy2. To that end we expect to go full cycle on several assets by the end of 2019. We are still on the lookout for interesting real estate opportunities and believe they will continue to show up at our doorstep. We turn down over 90% of the assets presented to us for consideration, but when we find those niche opportunities, we will pursue them with determination. This level of focus and commitment by our acquisitions team allows us to compete on factors other than price.
We thank you for the confidence you have placed in the Shopoff team and look forward to a fruitful 2019.
1 Linneman Report, Fall 2018 https://www.linnemanassociates.com/the-linneman-letter
2 There is no assurance that this strategy will succeed to meet its objectives.
The views, thoughts and opinions expressed in this outlook belong solely to the author. This outlook is based on current public information that we consider reliable, but we do not represent it is accurate or complete, and it should not be relied on as such. The information, opinions, estimates and forecasts contained herein are as of the date hereof and are subject to change without prior notification.
This market outlook is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. Readers should consider whether any advice or recommendation in this research is suitable for their particular circumstances and, if appropriate, seek professional advice, including tax advice. The price and value of investments referred to in this research and the income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur.