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RCG 17 Guide to Markets FINAL[1]


SECTION 1 | MARKET PERFORAMANCE Recent Large Market Performance With respect to metro market performance, fourth quarter unit-weighted average RED 49 occupancy as measured by Reis stood on 95.56%. Year-end occupancy declined -10 basis points from midyear and -24bps over the year. Realized 4Q17 occupancy was 34bps above RCR’s 95.22% forecast from March 2017. That forecast relied on Reis’s then current pipeline projection, which proved to be about 30% greater than actual 2017 deliveries. Adjusting for this overestimate, our year-end forecast would have projected a 95.5% year-end occupancy rate, representing only a -6bps forecast error. Unit-weighted average RED 49 effective rents increased about 3.9% year-on-year in 4Q17, down from 4.0% at midyear and 4.5% during calendar 2016. Adjusted for inflation (GDP Deflator), rents increased about 2.1% Y-o-Y, once again materially higher than the long-term 0.7% average. Our 2017 forecast published in March 2017 called for 4.0% Y-o-Y growth in 4Q17. Adjusting for realized supply the forecast would have been 3.9% (addition of new mostly class-A supply to inventory tends to elevate average rent and therefore the rent growth metric), within a few hundredths of a percent of the realized rate. Although apartment sales volume declined -5.9% from 2016 (RCA) cap rates continued to trend lower. The RED 49 unitweighted average B/B+ cap rate proxy was 5.17% in 4Q17, down -3bps over the year but slightly higher than the 5.16% cycle trough recorded at mid-year. Our estimates of RED 49 net operating income also were surprisingly strong for this late stage in the real estate cycle. Our estimate of typical 4Q17 B/B+ RED 49 property NOI is $2,136, representing a 4.6% increase over the year-ago period. We also estimate that the value the typical RED 49 unit increased 5.6% over the year to $176,351, producing a generic look-back total return of nearly 11%; once again unusually high so late in a market up-cycle. 8

SECTION 1 | MARKET PERFORAMANCE Macroeconomic Outlook GROSS DOMESTIC PRODUCT Fueled largely by optimism after the 2016 election, U.S. output growth accelerated throughout 2017. Growth expressed on both a seasonally-adjusted annual rate (3.2%) basis in 3Q17 and a year-on-year (2.5%) basis in 4Q17 represented the fastest expansions observed in two years. Likewise, current dollar (“nominal”) GDP, the output measure most closely correlated with apartment rent trends also increased at a brisk pace, rising 4.4% year-on-year. Personal income, another critical driver of rent, grew at a 3.8% annual rate in 4Q17, more than two times the near recessionary level recorded in the year-earlier quarter. At the same time, the rate of payroll job creation, the largest single catalyst of apartment demand, stopped decelerating for the first time in two years and managed a modest gain in 4Q17 to 1.53%. RCR’s 96.1% adjusted R-squared (standard error = 0.35%) GDP growth forecasting equation now employs six lagged variables: personal consumption expenditures (PCE), personal income (PI), payroll employment and M2 growth; the spread between the yields of Baa-rated corporate bonds and 10-year maturity Treasury securities; and the rate of change of the so-called GDP output gap, the measure of remaining slack in the economy. The variables with positively signed coefficients include PCE, job and M2 growth and the output gap, while the others act as counterweights. The positive coefficient predictive variables were mostly constructive, especially personal income growth and the Baa/10-year spread. Accordingly, the GDP forecast for 2018 is upbeat (Exhibit A). The equation projects that real GDP will expand at about 2.6% Y-o-Y rates in the first half of the year; about 2.2% in the second half. Corresponding nominal GDP growth projections are 4.6% and 4.1%. Payroll job creation is projected to reaccelerate modestly to a 1.65% quarterly average Y-o-Y rate in 2018. This translates to a net add of 2.43 million jobs, up from 2.27 million in 2017; good news for household formation and space demand. Personal Income is projected to rise nearly 5% this year, easily the best performance since 2014, with positive implications for rents. PCE and its corollary retail sales are likely to grow at a more moderate pace. On the other hand, risk, as defined as the distribution of probable outcomes, is increased. A Monte Carlo simulation finds that the probability of negative GDP growth in 1H18 is only 5%. But the computed probability rises above 20% in 2H18. The principal sources of risk are faster than expected increases in inflation and corresponding spikes in federal funds and 10-year Treasury rates. Exhibit A. RCR Base GDP Growth Forecast Souces: Bureau of Economic Analysis/RED Research Forecast Real GDP 4Q16 Forecast 4% Y-o-Y Rent Growth 3% 2% 1% 2.5% 2.0% 1.2% 1.3% 1.5% 1.8% 0% 2015 2016 2017 2018f 2019f 2020f 2021f 2022f 9

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