It’s U.S. Against the World: A Global Perspective on Domestic Commercial Real Estate
Bear Mar·ket (noun)
A market condition in which the prices of securities are falling and widespread pessimism causes the negative sentiment to be self-sustaining. Although figures can vary, for many, a downturn of 20% or more in multiple broad market indexes, such as the Dow Jones Industrial Average (DJIA) or Standard & Poor’s 500 Index (S&P 500), over at least a two-month period, is considered an entry into a bear market.
As of late January 2016, seven major global markets have been classified as bear markets since the beginning of the year. Led by China, the economies of Canada, Germany, France, the United Kingdom, Japan, and the Eurozone followed suit. Additionally, Switzerland, Australia, Russia, India, and all three major U.S. indexes had officially fallen into correction – a drop of 10% or more. Per CNNMoney’s survey of economists, the odds of the U.S. sinking into a full-blown recession was 18% and the Wall Street Journal’s survey of economists predicted a 17% chance. Citigroup, at the time, had predicted a 65% chance of a U.S. recession in 2016.
With this global gloom and doom, it was easy to see why investors were flocking towards safe harbors. At the time, one of the most popular ways to deploy foreign capital was through U.S. commercial real estate. Fast forward to the present and it is evident that the storm has calmed. All three major U.S. indexes have made up what was lost in January and February, oil seems to have stabilized around $48/barrel, and the worries of Chinese economic growth have subsided. However, several financial analysts, Sol Palha for example, now warn that the storm had calmed too quickly and that a major correction is due.
Regardless of when the market is bullish or when the market is bearish, as prudent commercial real estate (CRE) investors, we must consider the true driver of the economy: economic market fundamentals. The stock market almost never leads the economy into a recession. Bernard Baumohl, Chief Economist at The Economic Outlook Group, in a recent CNNMoney article said that “low interest rates, cheap oil prices, and the lowest input costs ever for business are not - and never will be - the precursors of recession”. In fact, per the Bureau of Labor and Statistics, American employers added approximately 2.65 million jobs in 2015, the second best year of job gains since 1999, and the unemployment rate has been cut in half since 2009 from 9.9% to approximately 5%.
In a nod towards the strengthening economy, the U.S. Federal Reserve, also known as the Fed, has identified this trend and responded by ending quantitative easing (QE) in October 2014 and the Federal Open Market Committee (FOMC) has finally lifted the U.S. interest rate above historical near-zero figures in December 2015. The possibility of a second raise at the June 2016 FOMC meeting has been steadily increasing since the release of the minutes from the last FOMC meeting.
Monetary policy theory tells us that with higher interest rates comes higher inflation – for example, with higher inflation, a $5 gallon of milk will cost $6 next year. Higher inflation, in turn, spurs devaluation of a currency relative to that of other currencies – if it costs $1.40 to buy £1 this year, next year it will cost $1.50 to buy £1. So, the textbook tells us that, given the current situation, the U.S. dollar should be experiencing a wave of steadily increasing inflation and devaluation relative to other currencies as expectation that the Fed will continue to raise interest rates through 2016 until it’s priced into the market. However, there are many factors in determining the value of currency. While inflation, GDP, and balance of trade metrics count among these factors, the current discrepancy between the typical interrelationship between interest rates and valuation of currency derives from potentially a more qualitative notion.
While the Fed looks to spur inflation, given the current state of the economy, the U.S. inflation rate stands at 0.7% for 2015 – a year where the market was expecting an eventual Fed rate increase that ultimately came in December. That stands as the lowest U.S. inflation rate in the post-Recession period, far from the target 2% inflation rate set by the Fed and inconsistent with the global inflation rate of 2.5% for 2015. While the dollar has recently began weakening, it still remains strong; a stark contrast to the current devaluation of most of the world’s currencies. It turns out that the overriding factors between the current increasing value of the dollar and potential inflation growth are the various events happening outside our borders.
- Outside of the U.S., many countries continue to weather economic turbulence at home. The following events highlight the economic uncertainty in the current global environment:
- EU and Japan have undergone new rounds of QE, a program of buying financial assets from commercial banks and other financial institutions to increase prices of those financial assets and lowering their yield while simultaneously increasing the money supply in an effort to spur economic growth.
- Japan joined the EU, Sweden, Denmark, and Switzerland in establishing a fee for deposits, effectively a negative interest rate, in order to disincentivize holding investments in cash and increase active investment and economic activity.
- There are staggering levels of inflation in Latin America, with the Venezuelan bolivar infamously inflating over 145% in 2015.
- Political unrest surrounding the impeachment proceedings of Brazilian President Dilma Rousseff.
- China has historically allowed the yuan to devalue, in addition to the overall economic slowdown and large amount of investment capital, both foreign and Chinese, leaving the country.
- OPEC and other major oil-producing countries are suffering from still relatively low oil and commodity prices due to the continuing global supply glut.
All of these major events and the overall economic fundamentals speak to the fact that the U.S., and specifically U.S. CRE, is potentially becoming more desirable for global investment capital simply due to the perception of stability relative to the rest of the world – the perception that the U.S. is the nice house in a bad neighborhood. Through the basic concept of supply and demand, U.S. CRE should continue to see further demand growth through 2016 as foreign capital continues to enter the country and, due to that, CRE fundamentals at a high level should see increasing rents, occupancy, and valuation. These increasing metrics will justify further development in markets popular with cross-border investors such as Manhattan, Los Angeles, Boston, San Francisco, and the tertiary markets in the West as supply continues to be constrained by increasing demand.
While Canada was the continued global investment leader in U.S. real estate in 2015, Singapore, led by the Government of Singapore Investment Corporation (GIC), is the undisputed leader in Asian capital investment, followed by China (based on RCA’s The Big Picture report from January). Through the remainder of 2016, we should begin to see an across-the-board increase in cross border property investment as the global economic storm continues to weather, with a new leader from Asia potentially surpassing Canada as other Asian currencies begin to follow the devaluation trend of the influential yuan.
In conclusion, regardless of the volatility that we have been seeing with the stock markets, the U.S. economy remains fundamentally healthy and the global environment provides more than adequate drivers for continued growth in U.S. CRE. Simply because weak Chinese manufacturing data throws the U.S. equity markets into turmoil does not mean it will do the same for U.S. CRE – in fact, the inverse may be true. As we go through the year and the inevitable market changes occur, always remember to evaluate through the perspective of a prudent real estate investor, rather than following the flow of the masses. By doing so, you will be able to identify opportunity through objectivity and potentially continue to reap success through 2016.
It is always important to note and remember that investing in real estate carries risks and that returns and capital preservation are never guaranteed. We recommend that investors conduct the due diligence before making an investment decision, regardless of where in the world they would like to invest.