Yield-Curve Inversion Reiterates Stability Of Commercial Real Estate

 

 

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FINANCIAL MARKETS AUGUST 2019
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Research Brief
Yield-Curve Inversion Reiterates Stability Of Commercial Real Estate
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Brief yield-curve inversion sparks volatility. The short-lived inversion of the 10-year and two-year Treasury yield curve sparked significant financial market volatility as the closely monitored sign of an impending recession delivered a warning alert. Despite efforts by the Federal Reserve and generally strong economic metrics, including steady job creation, low inflation, above-average retail sales growth and elevated small-business confidence, financial markets remain concerned about ongoing trade disputes with China. The flight to safety sparked by the uncertainty has pushed the 10-year Treasury rate to the 1.5 percent range, within 20 basis points of the record low set in July 2016. The convergence of these factors has delivered a unique window of opportunity for commercial real estate investors.

Financial market volatility reemphasizes security of real estate. The recent financial market swings reiterate both the stability of commercial real estate and the attractive yields offered by the sector. In addition, the exceptionally low interest rates currently available provide a strong levered yield premium, with the average combined commercial real estate cap rate of 6.3 percent exceeding the 10-year Treasury by 480 basis points, one of the widest margins this cycle. While this has the potential to attract additional capital to the sector, it also offers current investors an opportune time to reevaluate their existing portfolios. With risks of an impending recession elevated, real estate owners may consider more defensive asset allocations favoring single-tenant net-leased assets with a strong credit backing as well as sectors that generally fare well during weaker economic periods such as healthcare-related real estate. Diversification across markets with different economic drivers and across property types will also become increasingly important as the next economic cycle plays out. The window of opportunity could close quickly, however, as a resolution to the trade war could rapidly erase much of the uncertainty and spark a brisk rise in interest rates.

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Developing Trends
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Job creation maintains steady pace. The U.S. is on pace to hire 2 million new employees in 2019, sustaining unemployment in the upper-3 percent range as job openings still outnumber people seeking work by 20 percent. Sustained job creation remains a primary driver of domestic growth and real estate demand.

Spending picks back up as consumers stay optimistic. Core retail sales growth rose 4.2 percent year over year in July, after posting 3.8 percent gains three of the past four months. Elevated consumer confidence and solid wage growth continue to support spending, putting consumption above historical averages.

Stable economy keeps income levels on the rise. Disposable income remains at an all-time high on an inflation-adjusted basis, reaching $45,600 per capita in June. Year-over-year growth has remained in the mid- to high-2 percent range throughout 2019, reiterating the underlying strength of the economy.

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6.3%

Average CRE Cap Rate
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1.54%

10-Year Treasury Rate
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* Through Aug 16
Sources: Marcus & Millichap Research Services; Bureau of Labor Statistics; Federal Reserve Bank

 

Traditional Retailers Gaining Ground as Sector Evolution Continues

 


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RETAIL SALES JULY 2019
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Research Brief
Traditional Retailers Gaining Ground as Sector Evolution Continues
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Consumption rise supported by diverse drivers. Retail spending picked up in June, climbing 3.8 percent on an annual basis for the third time in the past four months. Stable consumption is supported by a strong economic foundation, highlighted by continued job creation and healthy inflation. The Fed will likely cut interest rates at the end of July, providing a boost to the economy.

Retail sector transformation balances e-commerce growth. Spending was headlined by familiar faces over the past year, with single-tenant staples in restaurants and pharmacies each witnessing approximately 4 percent growth. E-commerce again led all retail categories; however, growth in this segment has trended downward for the past year and a half. May marked the first month this cycle that e-commerce sales failed to reach double-digit growth. Though online shopping remains a key component of retail spending, its prominence has begun to moderate as experiential brick-and-mortar concepts gain more traction with consumers. The industrial sector continues to benefit from both types of retail, driving demand for distribution centers and warehouses. In 2019, roughly 20 percent of the nation’s industrial leases will be taken by retailers as they look to strengthen last-mile delivery strategies in dense urban areas as well as increase suburban footprints in response to demographic shifts.

Consumers showing more caution as obstacles arise. Spending on electronics and appliances is slowing on an annual basis, logging negative or no change for the past nine months as the economy sits in a more stabilized state relative to last year. Though increased consumption is still evident across many retail segments, discretionary spending on big-tickets items is moderating. Consumers are being slightly more cost-conscious as the cycle extends and geopolitical challenges persist.

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Developing Trends
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Employment growth picks back up. Job creation reached 224,000 in June, rebounding from May’s muted growth. Employment gains have been rather sporadic, producing a monthly average of 172,000 in 2019. Education and health services led all sectors during that time, adding roughly 320,000 positions; however, a labor shortage for medical workers still exists.

Retailers accommodative to evolving shopping patterns. Industrial space demand for retailers has substantially accelerated over the past several years. In 2008, retail trade accounted for just 14 percent of the nation’s industrial leases, while now approximately 20 percent of leases are occupied by retail companies.

Recent tariffs circulating through economy. The latest round of tariffs levied in May could impact consumers within the next couple months as companies’ additional materials costs leak through supply chains. This may alter consumer spending patterns as common goods could receive a price bump, potentially leading to higher levels of inflation.

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3.8%
Core Retail Sales Growth Y-O-Y
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9.5%

E-Commerce Sales Growth Y-O-Y
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* Through May
Sources: Marcus & Millichap Research Services; The Conference Board; CoStar Group, Inc.; U.S. Census Bureau

 

Interest Rates Trend Lower As Fed Responds to Trade War Uncertainty

 



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FINANCIAL MARKETS JULY 2019
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Research Brief
Interest Rates Trend Lower As Fed Responds to Trade War Uncertainty
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Fed has increasingly accommodative stance as trade battles weigh on economy. At its latest meeting, the Federal Reserve showed a greater willingness to ease policy rates in the near term. Chairman Powell pointed to weaker inflation and economic data, together with uncertainty amid trade tensions between the United States and China. The Fed reinforced its willingness to let inflation rise above the 2 percent level going forward, a notable shift in its historical policy framework designed to increase future flexibility. Wall Street has begun to price in rate cuts as early as the July meeting, reflecting a rapid shift toward more dovish policy. Rate cuts during an ongoing expansion would echo similar steps taken during the mid-1990s, when Fed officials responded to softening data by trimming rates three times. The recent trade detente reached between Presidents Trump and Xi at the G20 meetings in Tokyo has eased market concerns in the near term, yet ongoing uncertainty and the potential for re-escalation of tensions remain key considerations of Fed officials moving forward.

Yield spread widening as global interest rates plummet. As the 10-Year Treasury yield hovers in the 2 percent range, borrowing costs have followed suit. This has widened the yield spread between cap rates and lending rates for investments, allowing buyers more aggressive underwriting. Primary markets are likely to be the key beneficiary of this trend due to the razor-thin yield spreads in many property types, particularly highly desired multifamily assets. Lower interest rates could potentially boost market liquidity, as many economic metrics including low unemployment and stable wage growth still favor additional acquisitions. However, risks to the economic outlook remain, particularly in manufacturing industries where tariffs have already caused notable weakness. The impact of previously announced tariffs on consumer goods in the coming months should be closely monitored for risks of slowing consumption and economic growth.

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Developing Trends
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Subdued inflation aiding relaxed Fed stance. While job growth and wage trends are positive, inflationary pressures remain muted. Core CPI recently printed 2 percent, yet the Fed’s preferred metric, Core PCE, trended down to 1.6 percent. Both metrics allow the Fed ample latitude to execute policy as necessary without significant concern of sparking a bout of increased inflationary pressure.

International central banks place downward pressure on interest rates. Within the last month, both the Federal Reserve and the European Central Bank reiterated their willingness to act amid risks of a broader economic slowdown. This has placed significant downward pressure on interest rates, pushing more than $12.5 trillion in sovereign bonds into negative yields. Extremely low and negative rates reinforce the competitive benefits of commercial real estate, where cap rates range from the 4 to 8 percent range.

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2.25%
Current Fed Funds Overnight Rate
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1.6%

Core PCE in May 2019
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* Through June
Sources: Marcus & Millichap Research Services; Bureau of Labor Statistics; Federal Reserve Bank

 

Robust Job Growth Underscores Confidence in Apartment, Retail Sectors

 

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EMPLOYMENT JULY 2019
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Research Brief
Robust Job Growth Underscores Confidence in Apartment, Retail Sectors
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Recent hiring trends fall below pre-tax stimulus job growth. Employers created 224,000 jobs in June, bringing the total so far this year to 1.03 million. That is the lowest first-half sum since 2010, although comparable periods in 2016 and 2017 reported only slightly higher employment growth. The fiscal stimulus from tax reform encouraged greater hiring in 2018, but as those effects fade, staffs are expanding at a slower pace, further hindered by historically low unemployment.

Tight job market keeps Class C multifamily vacancy low. Greater employment and continued household formation are driving housing demand, particularly for rentals. Unemployment and apartment demand continue to move in sync as individuals with a range of experiences and education levels find opportunities. The correlation is especially strong for Class C units, which serve the broadest renter pool. The second quarter ended with a 3.7 percent unemployment rate and a Class C vacancy rate of 3.5 percent, a near-20-year low. High renter interest and limited availability are propelling effective rents up at a class-leading pace.

Higher earnings bolster discretionary spending, driving demand for retail services. Tight labor market conditions support an annual pace of wage growth above 3 percent, helping lift retail sales by a similar margin. Spending is improving at an even faster rate at restaurants and bars, up 3.6 percent year over year in May. Consumers continue to gravitate toward social experiences and the convenience of eating out, making dining an important driver of foot traffic for retail centers. Spending in grocery stores is also rising at a steady clip, prompting more store openings, especially for smaller format locations. Solid demand factors paired with subdued retail construction will contribute to one of the lowest vacancy rates in 20 years at the end of 2019 and rent growth above the cycle average.

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Developing Trends
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Labor market entrants decline amid hiring shortage. Total job openings continue to surpass the number of unemployed by about 20 percent. The strength of the labor market is empowering employees to change jobs more frequently, raising the number of people quitting their current position in favor of another. At the same time, the labor pool has tightened due to factors such as education. Labor force participation for people between the ages of 20 and 24 is lower compared with past cycles as more young people stay in school longer to obtain advanced degrees.

Higher earnings, trade tensions raise inflation risk. Stable wage growth aided by a labor shortage and the impact of existing tariffs may be behind the recent appreciation in consumer prices. Core CPI rose 0.3 percent in June, the highest monthly increase since January 2018, for a 2.1 percent annual gain. Inflation has been subdued this year despite upward economic pressures, which could begin to manifest in the near future.

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3.7%

June 2019 Unemployment Rate
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3.5%

2Q 2019 Class C Apartment Vacancy

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* Through 2Q
Sources: Marcus & Millichap Research Services; RealPage, Inc.; Bureau of Labor Statistics