Brexit: The most consequential story this year, and perhaps in decades, was the referendum in the U.K. to leave the European Union. Never quite fully engaged, the U.K. retained their own currency and island-like mindset when the European Union was created nearly forty years ago, as it refused to become part of the current nineteen-member state Eurozone. Domestically in the UK, the declining British Pound will drive inflation higher, crimping real incomes. It is likely that numerous jobs will leave, and hours worked and wage growth may decline as the free flow of goods, services, and trade with the rest of Europe is curtailed.
Although the U.K. has the fifth largest economy at current measures, it accounts for just 3.9% of the world’s output. Historically, recessions in the U.K. have had a meaningful impact on Europe’s economy, as Europe has experienced a drop of about half as much as the size of the reduction in U.K. GDP growth. It is highly likely that in the near to medium-term there will be an aversion to risk as global investors seek more stable assets and shift demand to investments in U.S. dollars, ushering in a renewed bout of dollar strength. The questions needs to be asked: are other international economic agreements in peril at this time as well, and what will be the longer-term fallout of the Brexit? The World Trade Organization recently indicated that protectionist trade measures in the G20 are being proposed at their highest rate since 2008. In such circumstances, it would not be surprising if the Brexit vote was the beginning of a negative effect on investment worldwide.
The United States economy still has to contend with significant challenges. Back in December, the Federal Reserve started to give the all-clear signal and raised rates 25 basis points (0.25%), with expectations for continued rate increases throughout 2016 as well. With international turmoil and the weak employment report from May showing the U.S. economy created the fewest number of jobs in close to six years, it will be next to impossible for the Federal Reserve to raise interest rates on the timeframe they were hoping for only a few short months ago.
At Tidegate Capital we have been discussing exceptional volatility in the financial markets for over a year now, and clearly volatility does not seem to be abating at this time. In addition to the Brexit vote, the upcoming G.O. bond default by Puerto Rico, which as recently as late 2013 had received stable ratings from Moody’s, will put pressure on the municipal bond market in general. Additionally, the question about the ability of rating agencies to accurately assess credit risk, which first arose in 2008 when AAA-rated securities defaulted, will come into question again. U.S. stock market activity has also been experiencing a resurgence of volatility, which in turn has driven investors to fixed income securities, and, in particular, U.S. Treasury Bonds, with their resulting yields heading to recent lows.
Real Estate Environment
Real estate has performed well, and we believe the fundamentals of the multifamily housing markets remain solid. As is common, there are a few metropolitan statistical areas that we are avoiding at this time due to an influx of foreign cash. Miami, New York, Denver, and San Francisco are a few examples where we believe the cap rates have become overly compressed.
Overall demand for rental units continues to be robust and even surged during the second quarter of 2016, adding to the impressive run that has driven rental rates higher in recent years. New supply has struggled to meet the demand, which is being driven by current low homeownership rates. As the millennial generation continues to move out of the basements and live on their own, they are fostering substantial growth in demand for apartments. While the affluent millennials favor urban environments with live-work-play options in lifestyle communities, the majority of their peer group continues to lease in suburban and second-tier cities where rents are more affordable. Looking ahead, an even larger demographic, the post-millennial generation, is on the horizon—which should stimulate even greater demand for housing.
U.S. apartment occupancy inched up to 96.2% in the second quarter 2016. However, regional variances remain significant as fast-growing metropolitan areas, particularly those near the coasts, reflect even tighter occupancy levels. While the improving rents, tight occupancy levels, and low homeownership seem unsustainable by recent benchmarks, it is important to note that from an historical perspective, current rental metrics that are being driven by the millennials are close to the long-term averages and are very similar to when the baby boomers were first starting out on their own in the 1960’s and 1970’s.
Long-Term Vacancy Rates Vs. Homeownership / Renter Rates