In the first half of 2018, the real estate sector had modest returns, trailing the performance of the S&P 500. Fundamentals remain strong along with liquidity, and we see no imminent sign of a downturn for the remainder of 2018. Despite our optimism, there are a few potential headwinds that we are watching including a decrease in transaction volume, higher interest rates, higher labor costs impacting capital budgets, and continued asset selling by pubic REITs.
We are approaching the second half of 2018 positioned for higher interest rates and flat-to-tighter spreads. Our focus continues to be on income generation and maintaining a yield advantage relative to the benchmark.
Boyd Watterson believes that advisors and consultants should keep their clients invested through the cycle to increase the likelihood that long-term investment objectives are achieved. We design our moderate beta strategies with this understanding in mind.
Our belief is that investment returns are significantly driven by macro factors such as inflation, economic growth, credit cycles, the level and direction of interest rates, equity multiples, and cap rates. We, at times, need to make minor adjustments to our strategies to ensure we are making the most of what the market offers.
Long term interest rates have been moving higher and the Fed is guiding to more rates hikes. Is this going to lead to higher cap rates and lower valuations, or will the large amount of uninvested capital keep a lid on cap rates?
The economic growth story remains for 2018, with inflation increasing at a measured pace. Additionally, corporate earnings growth rates are high, warranting an overweight to corporate credit in our view.
Longer-term leases tend to benefit both GSA tenants and property owners. A typical GSA tenancy is more than two decades long whereas an average lease is 10 years, with 5-year extension options being typical. Structuring a longer-term lease that more closely matches GSA tenancy can result in cost savings through lower rents. Property owners, in turn, may experience higher property values due to more stable occupancy, potential reduced costs, and potential better financing terms.
Recently, there has been a widening in the spread relationship between LIBOR (London Interbank Offered Rate) and OIS (Overnight Interest Swap Rate). This prompts the question: Should this be of concern? Is it a “canary in the coal mine” signaling possible problems with overall bank credit, or is there some other viable explanation?
The Fed has communicated that it anticipates raising the federal funds rate three times in 2018, while the futures market implies only 2.5 hikes and many investors are calling for four moves. We fall into the three-hike camp.
Many private real estate strategies are set up as closed-end vehicles, a type of fund structure that can expose investors to “vintage risk.” Vintage risk is the risk that a large portion of a real estate fund’s properties are acquired during a period of high prices, making it difficult to sell them for a gain in the future.
In our view, high-quality income generation—and not capital appreciation—will be the primary determinant of real estate returns over the next few years.
Given the surprisingly solid bond market performance of 2017, what might fixed income investors expect in 2018? Unfortunately, lower returns. Despite favorable risk asset performance expected from strong earnings growth and ongoing demand, in our view investors should not expect to earn a return higher than the yield of the Bloomberg Barclays Aggregate Index, which was 2.71% at year end. Instead, we believe investors are likely to experience higher volatility and lower returns this year versus what they enjoyed in 2017.
For several years, we have referred to the US economy as a “caterpillar” economy. Since the 2008 Great Recession, the economy has inched along, alternately accelerating and decelerating, as it continues to steadily gain ground. For 2018, we foresee another year of caterpillar-like growth.
Synchronized Global Expansion Fosters Optimism
The challenges of the current low-yield environment call for investing strategies beyond conventional rising-rate investment solutions. Fixed Income investors seeking higher income, principal protection, and risk mitigation should consider diversifying their bond holdings with a portfolio of low-duration, mid-grade securities.
How will the markets react when the central bankers begin to unwind their bond positions?
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