6 months ago

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 12

SECTION 1 | MARKET PERFORAMANCE Metro Investment Ramifications In the Mid-year 2017 GTM we considered the principal challenge at hand for portfolio investors was to identify markets that will perform well under sluggish growth economic conditions. The situation hasn’t changed dramatically since. RCR continue to favor Southeast and Southwest “growth markets.” Rent growth prospects in these metros are constructive and initial yields are 25bps to 75bps higher than in the coastal primary markets. Additionally, the southern tier growth markets appear better-positioned than many to absorb the substantial supply that is in the pipeline. With respect to rent growth Charlotte, Dallas, Fort Worth, Jacksonville, Nashville and Raleigh are projected to record compound annual gains of 3.6% or faster over the five-year forecast interval. Their inventory-weighted average rent growth rate is 3.735%; average purchase cap rate is 5.25%; and average ETR is 7.52%. As for risk-adjusted returns, the group average Risk-adjusted Index (the ratio between the ETR and the standard deviation of ETRs determined by a 10,000 iteration Monte Carlo simulation) is 4.91. By way of comparison, the average expected rent growth rate of the 15 metro components of the seven primary markets is higher on 4.15%, but the average cap rate and ETR are lower on 4.94% and 7.45%, respectively. Moreover, the primary markets are equally or more volatile than the select growth market group, lowering the inventory-weighted average RAI to 3.57. In sum, a portfolio consisting of assets in the select growth markets appears to have better return and tighter return distribution prospects than a size-weighted primary market portfolio. But investors should not abandon the primary markets altogether. The outlooks for several remain promising. The best choices among the primary markets include the three Bay Area metros, Los Angeles, Miami, New York (in spite of its recent rent growth issues) and Seattle. Rent growth among this group is projected to average 4.4% over the forecast interval; the average ETR is projected to be 7.89% and the average RAI is 3.63, superior to the select growth market group except for risk-adjusted return. Table I. Top 10 Metros for expected Total Return Rank Metro ETR 1 Los Angeles 8.5% 2 Salt Lake 8.0% 3 Chicago 7.9% 4 Milwaukee 7.9% 5 San Francisco 7.8% 6 Cleveland 7.8% 7 Nashville 7.8% 8 Pittsburgh 7.7% 9 Charlotte 7.7% 10 Raleigh 7.6% Table II. Top 10 Metros for Risk-Adjusted Index (RAI) Rank Metro ETR 1 Cleveland 7.11% 2 Philadelphia 6.78% 3 Milwaukee 6.18% 4 Dallas 5.74% 5 Saint Louis 5.71% 6 Kansas City 5.64% 7 Forth Worth 5.28% 8 Suburban Maryland 5.16% 9 Indianapolis 5.08% 10 Chicago 5.07% By contrast, the balance of the primary markets (Boston, Capital Area, Fort Lauderdale, Palm Beach, Orange County, Inland Empire and San Diego) compare poorly. The group average rent CAGR and ETR are only 3.4% and 6.36%, inferior to the select group by 1.0% and 1.5%, respectively. Four smaller markets also may generate attractive investment returns: Nashville, Portland, Sacramento and Salt Lake. Heavy supply burdens notwithstanding each market has the potential 13

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