After the U.S. real economy was hit hard by the epidemic, the real estate sector also showed a clear K-shaped recovery. Office, hotel, retail, etc. have become K-shaped strokes toward the bottom, while residential properties, especially single-family homes, have not only become K-shaped strokes toward the top, but also become one of the important boosts in the early stage of economic recovery, with new home construction driving a series of upstream and downstream economic activities such as construction, materials, and home production.
The Case-Shiller National 20-City Composite Home Price Index as of the end of October was 235.77, up 7.95% year-over-year and the largest gain since June 2014; the number of home sales across the U.S. in October was 6.86 million, a record high since 2006. Interestingly, after reaching a high of 69% in 2007, the homeownership rate for Americans has continued to fall to 64% over the past 10+ years due to the fallout from the financial crisis, only to rise to 67% in just a few months after the epidemic.
The reasons for the strong recovery in U.S. residential real estate are multi-faceted, including the change in consumer behavior under the epidemic, the support and gradual improvement of telecommuting technology, and the preference for people to consider larger living spaces or move to the suburbs; the significant reduction in loan costs, with the U.S. 30-year fixed mortgage rate hitting a new low of 2.66% and still hovering at an unprecedented low level; and the oversupply of housing units. The housing vacancy rate is at a new low in the past 20 years, and due to the epidemic construction progress has been affected by the shortage of housing supply for sale, with the latest housing inventory reported at a new low of 1.28 million. Then there are the measures taken by banks under the government’s advice to “repay interest but not principal” and to suspend repossession of overdue homes for auction. The amount of foreclosed homes in the U.S., as a percentage of all mortgages, is at its lowest level since 1984.
However, despite the residential segment’s significant share of real estate, the performance of overall real estate investment trusts (REITs) continues to be weighed down by hard-hitting segments such as office, hotel and retail.
In terms of full-year performance in 2020, the U.S. REITs Index, compiled by FTSE and the National Association of Real Estate Investment Trusts (NAREIT), an all-equity index covering 162 U.S.-listed REITs, ended down 5.1% in 2020, slightly better than the 8.2% decline in the REITs Index covering developed regions of the world, and nearly 10% of that price recovery came in the last two months of the year.
Specifically, the largest declines were recorded in the retail real estate sector, including malls and shopping centers, which fell 25.2% for the year, followed by hotel/resort centers and office space, which fell 23.6% and 18.4%, respectively. The best performer, unsurprisingly, was the data center sector, up 21.0%, with positive returns in the industrial, personal storage, and infrastructure-related sectors as well. Borrowing from the “Big Four” concept commonly used in the contemporary art world, these four sectors became the “Big Four” of REITs investing.
In the residential sector, despite a 6.0% gain in single family homes, the overall residential sector fell 10.7% due to a decline in high density apartment traffic. This also shows that the change in asset prices of publicly traded REITs is something that does not exactly match economic indicators that show market activity such as new home sales and manufactured home sales.
These are return data from publicly traded REITs, which tend to be relatively more volatile in price and influenced by equity markets, while private real estate markets are relatively less volatile and many are income stabilization oriented. In fact, few public funds investing in public market REITs worldwide earned positive returns in 2020, but headline private funds investing in non-public REITs continued to provide positive returns to investors in a shaky 2020, largely due to their focus on laying out in the “Big Four” that benefited from the epidemic ” segment.
For both indirect as well as direct real estate investments, including in the form of REITs, we recommend looking at their investment returns with a longer time dimension. From a total return perspective, REITs have underperformed the S&P 500 over the past decade of the U.S. stock bull market, with annualized returns of 8.3% and 13.0% for both over the past decade, respectively. However, over a longer period of time, the annualized returns over the past 20 years were 9.8% and 6.3%, respectively, and REITs also outperformed the S&P over the past 30 years.
From a yield perspective, REITs have outperformed the 10-year U.S. bond on average for the vast majority of the past 30 years. And generally speaking, average U.S. rental yields are also generally higher than most of Europe and Asia, with higher rental yields in major cities around the world, including Philadelphia and Chicago, where rental yields are over 8%, and major cities in Europe and Asia ranging from 1% to 4%.
Some voices may question whether the strong performance of parts of the U.S. real estate sector after the epidemic was just a flash in the pan or a bubble. However, we believe that this is not the case, and we have found some data to support the recovery in the US real estate sector compared to the 2008 financial crisis.
First, in terms of disposable income, the impact of the epidemic was greater in the earlier period than in the financial crisis. 2008 saw a 2% drop in disposable income in the month following the crisis, while the new crown epidemic brought a drop of over 8%.
The difference is that in the two months following the outbreak, disposable income rebounded to a 15% increase in the year-over-year period, up 13% from the pre-outbreak period, thanks to the rapid implementation of government subsidies and the timely availability of unemployment insurance. In contrast, disposable income remained down for five months after the outbreak of the financial crisis and only gradually recovered to pre-crisis levels six months later.
Second, at the beginning of the epidemic, the city closure measures led to a rise in private savings to 34% of disposable income, which has remained at 10-20%, higher than the pre-epidemic ratio. In contrast, this distribution was not seen in the 2008 financial crisis, where the share fluctuated only around 5%.
This is related to the different nature of the two shocks: the external shock of the epidemic only suppressed residential consumption in the short term and was related to the role of government subsidies under high unemployment; while in the US, the internal industrial restructuring after the financial crisis made the real consumption power strong and will also be gradually released.
Taken together, we believe that the sales market of the leading residential sector in the U.S. real estate industry, as well as the rise in home prices, is not a flash in the pan, but sales and the market may slow down next. The reasons behind this include a sudden burst of home buying enthusiasm in the short term that may be absorbed, homeownership rates reaching historically high levels, and mortgage fixed rates that are likely to be at the end of a downward trend. In addition, some large companies may adjust compensation based on the relatively low price levels of telecommuting employees’ locations, which could affect employees’ willingness to improve their housing.
However, the demographics of Americans with the highest percentage of 30-39 year olds constitute a long-term positive for real estate. Considering that this group was deeply affected by the psychological impact of the 2008 financial crisis and has not been proactive enough to invest in the real estate market over the past 10 years, this part of suppressed demand is likely to continue to be released in the future. The age structure distribution of mortgage data clearly shows that this group is the main force of home purchase in 2020.
In fact, some of the post-80s and post-90s in the U.S., despite coming from mid-career families and growing up in the suburbs, used to be reluctant to live in the suburbs as their parents did, and were instead keen to pile up in the city or suburbs. And the epidemic has changed all that, as they flee the big cities and return to the suburbs they grew up familiar with to grab a house.
In the medium to long term, economic recovery, supply and demand, lower loan costs and a solid investment environment will provide support, while a diversified portfolio diversified across residential, industrial, warehousing, data centers, etc. is expected to capture future price restoration in the damaged sector and long-term growth momentum in the beneficiary sectors.
However in the broader environment we also have to be concerned about the following risks. While the vaccination program is progressing well in the U.S., the number of confirmed cases in the U.S. broke a new high of over 300,000 in a single day, and the recurrence of the epidemic is closely related to the repair of sectors related to the real economy in real estate, which is not similar to the minimal impact of the recurrence of the epidemic on capital markets.
Second, the clarification of the political situation in the U.S. has been accompanied by frequent outbreaks of divided opinions and violent clashes in parts of society caused by the election. In addition, we also need to pay attention to the market’s ability to self-regulate after the future exit of fiscal and monetary policies, which is crucial for long-term investment and has a cyclical nature of the industry.