A new generation of house hunters enters a U.S. market near historic lows in listings, setting the stage for what could be another residential market boom.
For the better part of a decade, average U.S. commercial real-estate prices have climbed relentlessly, not only recovering all the value lost during the 2008-09 financial crisis, but also far exceeding the pre-crash heights of 2006. Meanwhile, U.S. housing prices have recovered as well, but in a more intermittent fashion, and barely topping the 2006 peak.
One of the key drivers of the forecasted increase in U.S. housing prices is the sheer number of U.S. Millennials ready and able to form new households and buy a new home.
This year, though, all that might be about to change. According to a recent Morgan Stanley Research report, U.S. commercial real-estate pricing in 2017 could drop by as much as 10%, year over year, amid slowing revenue growth, rising interest rates and tightening lending conditions.
On the other hand, U.S. housing prices this year could increase by as much as 4%, annualized, says Vishwanath Tirupattur, Morgan Stanley’s Head of U.S. Fixed Income Research.* Several factors could lift housing prices: An increase in potential home buyers, fueled by the growing ranks of Millennials—those born between 1980 and the early 2000s—poised to form their own households, combined with a near-historic lack of single-family homes for sale and growing access to mortgage credit. For investors, the trends offer opportunities in several sectors dedicated to home improvement and credit.
U.S. Housing Prices Have Risen Steadily
The Young and the Restless
Remember a few years back when, instead of heading out into the world, droves of young people either stayed, or returned to live, with their parents, or ended up having more roommates in even tighter quarters to make the rent? Their arrested development, in no small part due to the prior housing market decline, created pent-up demand in a key demographic. “One of the key drivers of the forecasted increase in U.S. housing prices is the sheer number of U.S. Millennials ready and able to form new households and buy a new home,” says Tirupattur. In other words, they are now finally ready to leave the nest and drive additional demand for shelter.
Indeed, the 15- to 34-year-old U.S. population accounts for 26.4 million households. “Taking this generation's diversity into account, our forecast for household formations over the next five years is 6.50 million to 6.75 million, or 1.30 million to 1.35 million per year, which is over 30% higher than the long-term average rate of household formations,” Tirupattur says.
Slim Pickings for Home Buyers
Meanwhile, the supply side of the housing equation is sitting at historically low levels. The National Association of Realtors puts listed U.S. residential inventory at its lowest point in the 18 years that it has been tracking this data. If only single-family homes are considered, only once, in February 1994, has the number of available listings for sale been as low as it is now. While new single-home construction rates have risen for five straight years, they remain well below the average rates of 2000 to 2003.
Inventory of Existing Homes for Sales Is at Its Lowest
“This historic lack of inventory will remain a tailwind for home prices and a headwind to both existing and new home sales,” says Tirupattur.
Commercial's Challenge
The outlook for commercial is decidedly different. The forecasted 5% to 10% decline in average U.S. commercial real-estate prices would be the first of such magnitude for the $6.2 trillion market, absent a recession, in history. The sector has roared back from the housing crisis, with average prices 157% higher than the 2008 peak.
Capitalization rates, despite a recent uptick in some markets, have declined steadily for several years. However, lending standards for commercial real estate tightened in 2016 for the first time in several years, notes Richard Hill, who is the lead U.S. real-estate investment trust (REITs) analyst, focusing on commercial-mortgage-backed-securities strategy in the Fixed Income Research group.
“Occupancies and rents are already near historical highs, pushing net operating income growth to about 5%, which isn't sustainable relative to the historical average of 2.5% to 3%,” Hill says. “Decelerating revenue growth is insufficient to offset rising rates and tighter lending standards headwinds. As a result, either property values will fall, like we expect, or margins suffer.”
Investment Implications
The forecasted increase in housing prices amid a predicted decline in commercial real-estate prices offers some opportunities for investors. Given the surge in demand for housing driven by Millennials and the historically low availability of homes for sale, investors could consider single-family rental REITs, as well as multifamily REITs. Morgan Stanley also is bullish on senior housing REITs, as well as industrial REITs, noting that new housing construction traditionally has driven industrial demand.
Other real-estate-related sectors also stand to benefit. Home improvement retailers, for example, often get a lift from a housing-price increase cycle, which Hill characterizes as in the “middle innings,” with more growth still to come.
As commercial real-estate prices decline, investors could consider banks without a heavy emphasis on commercial real estate lending, and stay away from those that may be overexposed.
For more Morgan Stanley Research on the outlook for the real-estate sector, ask your Morgan Stanley representative or Financial Advisor for the full report, “Bringing it Back Home: 15 Plays on the Housing/CRE Divergence” (Mar 29, 2017). Plus, more Ideas.
*Vishwanath Tirupattur is a Fixed Income strategist and, as such, is not opining on equity securities.
