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As the Cycle Turns

By Ben Viemeister, CFA
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The property recovery cycle has led to outstanding homebuilding and commercial real estate annualized returns relative to most other asset classes over the past five years. All cycles turn, however.

Commercial Real Estate

From 2010 – 2015, domestic commercial real estate of all sub-classes experienced demand exceeding new supply. This drove above average rent growth and took occupancy rates from below to above long-term norms. Apartment, industrial, lodging, regional mall, and self-storage commercial real estate sub-classes are at or just below record high occupancy rates. Encouraged by accelerating commercial real estate revenue and profit growth, banks loosened commercial real estate lending standards throughout this period.

Tight occupancy and loose lending incentivized new supply that is finally getting delivered. Problematically, delivery of this new supply is happening as profit growth is beginning to decelerate from cycle high growth hit in the first quarter of 2016 and liquidity conditions have begun to tighten. This mix of increased supply in the face of decelerating demand and tightening interest rate and lending conditions has historically marked the latter part of past commercial real estate cycles. Examples of supply, decelerating profits, and tighter liquidity are highlighted in the following chart:

This deteriorating fundamental picture is happening as commercial real estate valuations remain expensive for private market assets and publicly traded assets like Real Estate Investment Trusts (REITS). At best, a few commercial real estate valuation metrics are just above their long‐term averages. But in many cases, commercial real estate valuation metrics are near record highs.

Valuations in many cases within commercial real estate do not protect investors against further worsening of profit growth as the cycle matures. Now is not the time to buy commercial real estate aggressively.

Residential Real Estate

The real estate allocation is not just made up of commercial real estate assets. Residential real estate is part of it, too. It is true that new home starts remain well below the peak set in the housing bubble around a decade ago. Yet a growing number of housing cycle indicators have started to flash yellow.

Existing home prices recently hit a record. Mortgage application growth is slowing. Mortgage rates are increasing. The Housing Opportunity Index, which tracks affordability, recently hit the lowest level since 3Q08. Valuations for housing‐related companies are becoming less compelling. These developments warrant close monitoring.

Portfolio Strategy

The conditions discussed above have led OPCM to trim the real estate allocation in 2016. For example, OPCM trimmed its apartment investment in the first quarter of 2016 and eliminated it at the start of the third quarter. As a result, the allocation is at the low end of its historical range. At its peak over the last ten years, the real estate allocation reached just over 10%. Today, it is around 5%.

Going forward, it is possible the real estate allocation may decrease further. Both commercial real estate and housing‐related assets may get trimmed in the first half of 2017, if valuations do not improve and fundamentals continue to deteriorate. In the meantime, OPCM is building its real estate watch list of potential assets to buy, if presented with attractive opportunities.

Why maintain an allocation at all to real estate? The property cycles may reaccelerate, perhaps triggered by new policies from Washington. The asset class provides diversification. Real estate is global and the allocation includes international real estate, where valuations are not as expensive and property cycles are not quite as mature as the United States.

Ben Viemeister, CFA

Ben Viemeister, CFA

Ben is an Investment Analyst at OPCM and has over 10 years of experience. Ben is a member of the OPCM Investment Management Team, and is responsible for research coverage in all asset classes. Ben is a member of CFA Society San Francisco and CFA Institute. Ben graduated summa cum laude from Lynchburg College with a B.A. in Economics and is a CFA Charterholder.
The opinions expressed herein are strictly those of Osborne Partners Capital Management, LLC ("OPCM") as of the date of the material and is subject to change. None of the data presented herein constitutes a recommendation or solicitation to invest in any particular investment strategy and should not be relied upon in making an investment decision. There is no guarantee that the investment strategies presented herein will work under all market conditions and investors should evaluate their ability to invest for the long-term. Each investor should select asset classes for investment based on his/her own goals, time horizon and risk tolerance. The information contained in this report is for informational purposes only and should not be deemed investment advice. Although information has been obtained from and is based upon sources OPCM believes to be reliable, we do not guarantee its accuracy and the information may be incomplete or condensed. Past performance is not indicative of future results. Inherent in any investment is the possibility of loss.