RCG 17 Guide to Markets FINAL[1]

SECTION 1 | MARKET PERFORAMANCE
Red 49 Performance Forecast (continued)
RED 49 EXPECTED TOTAL RETURNS
The weighted average five-year expected total return (“ETR”)
of the RED 49 declined -10bps from 2Q17 and 3Q17 to 7.0%.
Faster NOI growth projections in 4Q17 are largely offset by
higher terminal cap rate forecasts.
The ETR estimate would be higher had RCR not changed the
model it uses to project U.S. housing appreciation (FHFA Alltransactions
Home Price Index). The new model employs fewer
economic variables, elevating the relative effect of interest rates.
Both models are nearly identical with respect to adjusted-R 2 ,
standard error, Durbin-Watson statistic and Akaike information
criterion, the principal statistics that we rely on to determine
whether an equation is robust, reliable, unbiased and inclusive
of most of the authentic economic drivers. Like the old model
the new one projects a decided slowdown in appreciation over
the forecast interval but, unlike the previous equation, does
not produce negative growth point estimates. The old model
forecast negative appreciation beginning in 2020. Logically, we
consider the old model unrealistically negative in light of the
weak housing supply response observed so far in this recovery/
expansion phase.
The impact of the new model on ETR is negative. Higher home
prices contribute to reduced apartment demand and weaker
rent growth, all things being equal, and thus lower ETR in the
majority of markets. Although the old model contributed to an
accurate rent projection for 2017, we feel the new model will be
more reliable going forward.
With respect to cap rates, the group inventory-weighted
average now is expected to rise 67bps over the five-year
forecast interval to 5.84% (Exhibit D). In 4Q16, the expectation
was for a 50bps increase to 5.70%. The principal catalyst is the
10-year Treasury rate forecast. In the earlier analysis, the 10-
year yield was projected to rise 110bps over the course of the
forecast interval to 3.2%. The latest iteration foresees 100bps
increase from the 4Q17 average rate to 3.42%.
The outlook for operating fundamentals is promising, but
the inflation and interest rate outlook has deteriorated.
Consequently, we expect terminal cap rates to be higher
than under the slow growth/low volatility conditions that we
expected six months ago. This change shaves 5-year ETRs
moderately, but considering the late stage of the economic and
real estate cycles these are relatively good problems to have.
Exhibit D. RED 49 Cap Rate History and Forecast
Souces: CoStar Histories / RCR Projections
4Q16 Cap Rate Forecast
4Q17 Cap Rate Forecast
6.00%
Y-o-Y Rent Growth
5.75%
5.25%
5.25%
5.20%
5.17%
5.70%
5.84%
5.00%
4.75%
2015 2016
2017 2018f 2019f 2020f 2021f 2022f
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