Let’s be honest: Real estate valuations are very high today. But worries of an impending housing crash are premature. There are many trends that could continue to drive real estate values. A millennial middle class hungry for the independence of owning a home and a reasonable economy outweigh housing indicators that might signal a downturn is imminent. That doesn’t mean U.S. real estate markets are not in a pivotal phase. In fact, 2019 is poised to create significant opportunity for those who understand the five significant economic and demographic trends driving the market. Let’s consider the following five trends:
1. Rise in Interest Rates
Predicting Federal Reserve actions on rates is impossible. The Fed has wound down its unprecedented bond-buying program triggered by the 2008 financial crisis. Although mortgage rates have been in decline over the past several months with the 30 year mortgage around 4.5%, many analysts see mortgage rates rising on average to a high of around 5% on a 30-year fixed in 2019 and remaining at that level. As of this writing, the Fed’s next rate decision is a few weeks away and (at its mid-March meeting). It is widely expected that the fed funds rate will remain in the 2.25% to 2.5% and will delay any future rate hikes. However, mortgage rates geared off the 10-year Treasury rate may rise and increase the cost for real estate buyers and investors.
Some real estate price softening will be seen where cost of financing is critical. Given the amount of institutional capital chasing multifamily and industrial real estate investments, I expect investment activity to continue with lower IRR return expectations.
There are 74 million millennials, a larger demographic than the huge number of baby boomers. So follow the millennial money. Many millennials are at prime homebuying age, and they continue to push trends in the real estate industry. Millennial homeownership rates are below the national average of 64%. That represents a deep well of demand that could convert to 10 million home purchases. With the average millennial homebuyer having a reasonably high household income at $88,200, millennials have the means, and they want to buy first homes.
The year 2020 marks the pinnacle of millennial homebuying. For the next decade, this generation will represent the largest share of the market. The desire for their first home may continue to push single-family home prices higher in select markets. If prices are seen as too high in some markets, then millennials will focus on newer, expensive rental properties.
High prices in first-tier cities are forcing many homebuyers and investors to consider second-tier cities in search of better value. This trend is likely to continue through 2020. The influx of capital to second-tier markets is driving double-digit growth in investment activity and price appreciation. Major employers such as Toyota have pulled out of Southern California and relocated to the Dallas metro area. Apple is opening a billion-dollar campus in Austin, and Amazonis opening HQ2 just outside Washington, D.C. These moves, and others like them, may be signs that economic growth could support continued rising real estate values in second-tier markets.
In a typical late cycle, capital leaves the overvalued first tier such as New York and San Francisco and flows to the less-expensive second tier. Eventually, capitalization rates in the two markets converge. Premium cap rates on secondary market investments range from 75 basis points to 100 basis points higher than major markets and a full 300 basis point higher than top tier cities. Expect to see rising property values in the secondary cities, which will reduce cap rates.
4. Housing Affordability
Currently, renting is more affordable in 59% of U.S. housing markets, and home prices have continued to increase more than wages in 80% of markets, according to an analysis by ATTOM Data Solutions. So, expect continued strong rental housing demand rather than continuing single family home price increases. Evidence of this shows up in strong markets such as Seattle, San Jose, Las Vegas and Portland, where the number of homes for sale rose last year, but the share of affordable homes fell, due to rising home values and increasing mortgage rates. Multifamily investors will be rewarded in markets where housing affordability is strained.
According to ATTOM, it has gotten increasingly difficult to afford a home purchase in virtually every market with a population over 1 million. Currently, it is more affordable to rent than to buy a home in Miami, New York City, Seattle, Las Vegas, San Jose, San Francisco and Boston. It’s my take that this will push rents higher, making multifamily investors happy.
5. Impact of Opportunity Zone Funds
Real estate investors should consider a new tax incentive included in the Tax Cuts and Jobs Act of 2017 for investments in real estate in qualified opportunity zones (QOZs). The provisions include deferment, reduction and complete elimination of capital gains taxes for certain investments. I believe local expertise in these markets is a requirement and fold it into my company’s own QOZ Fund offerings, because local operators will have the best understanding of these opportunities. It is projected that $6 trillion in unrealized capital gains are eligible for QOZ investment, which could result in very strong real estate values in these QOZs. With core property in first-tier markets flooded with capital, the right investment in a QOZ with the right local partner could be a diamond in the rough.
The Bottom Line
There are certain drivers that will push rents and home prices higher. For longer-term real estate gains, the trends of millennial renting and buying upscale homes, the increasing prices in secondary markets, and capital flowing to opportunity zones will provide great opportunities to make outsize returns. A disciplined approach to real estate investing can uncover opportunities that lead to outperformance with less risk.