A Global Perspective on Domestic Commercial Real Estate
Harvard economics professor Sendhil Mullainathan once said that “January is always a good month for behavioral economics: few things illustrate self-control as vividly as New Year’s resolutions. February is even better, though, because it lets us study why so many of those resolutions are broken.” At the same time while most of us were making New Year’s resolutions (and eventually breaking them), economists were busy publishing their 2016 outlook and prediction reports for the U.S. and global economies. Just as we will see for our New Year’s resolutions, we will also see how behavioral economics play out for the behavior of economists in 2016.
Let us review some of the economic “resolutions” we have seen so far. The most drastic contrast in economic opinion could possibly be between two major economic outlook reports published by Morgan Stanley and Citigroup. Morgan Stanley has reiterated its projection that the U.S. economy has enough steam to continue economic expansion into 2020, originally predicted in a September 2014 report titled “2020 Vision: Long Live the Expansion”, effectively projecting the longest domestic expansion in the post-WWII era. Citigroup, in it’s “Investment Strategy Insights” Report published December 2015, is taking a more pessimistic view by predicting that there is a 65% probability of recession in 2016. With Wall Street posting minimum gains for 2015, and erasing those gains during the first two weeks of 2016 in the worst ever start to a year since recordkeeping began in 1897, it is not surprising that Citi Group is taking a cautionary outlook at the onset of the new year.
Take note, though, that regardless of whether you are Team Bulls or Team Bears, these reports share parallel economic risk factors that you, as a prudent commercial real estate (CRE) investor, must recognize. One must appropriately judge the potential implications of these economic factors on this specialized asset class. While the S&P 500 ended 2015 in a similar position to where it started (loss of 0.71%), Moody’s and Real Capital Analytics report that CRE values grew approximately 12% through 2015, continuing strong year-to-year growth since 2010. (https://www.rcanalytics.com/Report/34373/Report.aspx) There are various dynamics in why the same economic factors pushing down securities on Wall Street are driving up CRE on Main Street as part of the respective cycles. CRE market fundamentals continue to show healthy growth, with cap rates – the percentage of property return relative to net operating income – displaying continued modest compression and strong international demand in U.S. CRE assets, with the U.S. driving roughly 50%% of global transaction volume in 2015 up from 42% in 2014. (https://www.rcanalytics.com/Report/34373/Report.aspx) Knowledge of these driving economic factors are invaluable for a prudent investor with a global perspective on domestic CRE.
With all that being said, I would like to take a different spin on the typical economic outlook commentary. This series will cover five macroeconomic factors to consider in 2016 for Commercial Real Estate investors, based on what has been published and readily available in January. We will be following these factors through the next couple months as the economy takes its course. Has the U.S. turned into a safe harbor for the world’s investment capital? Will a flood of Chinese capital inundate the U.S. CRE markets as the yuan continues devaluation? Is oil going to collapse to $10 per barrel and will it take CRE with it? Will Mario Draghi continue Eurozone QE and will doing so effect U.S. cap rates? How would potential currency flux in East Asia effect your multifamily apartment building in San Jose? What in the world is behavioral economics?
All of these questions and more will be addressed in this RealtyMogul.com exclusive blog series.
1) Nice House in a Bad Neighborhood – U.S. Versus the World
A troubling fact that we must accept in this current economy is that the U.S. is, as the saying goes, the nice house in a bad neighborhood. The U.S. economy has shown strong year-to-year market fundamentals with strong employment data, growing job demand, and increasing corporate profits, all contributing to a healthy stock market recovery relative to that of comparable indices internationally. The U.S. Federal Reserve, also known as the Fed, has identified this trend and responded by respectively ending quantitative easing (QE) in October 2014 and the Federal Open Market Committee (FOMC) finally lifted the U.S. interest rate above historical near-zero figures in December 2015. Due to these actions by the Fed, the value of the U.S. dollar continues to grow; a stark contrast to that of most of the world’s currencies. PWC’s 2014 Emerging Trends in Real Estate report states that, in a survey of foreign investors 81 percent of respondents “intend to increase their portfolio of assets in the U.S.,” which “is perceived to provide a stable environment in which to invest and is the best market for capital appreciation”. A simple matter of fact, given the established situation, is that the U.S. has become a haven for the world’s capital, as international investors seek to find a foreign safe harbor to weather the economic storm at home. What implications will that have on your CRE holdings?
2) Rise and Fall - EB-5 and China
Practically everyone in the world recognizes that the former sleeping giant is starting to feel drowsy once again. As China prepares to shift from a manufacturing driven economy to a consumer driven economy, similar to that of most developed countries, all of us are starting to feel the growing pains. Due to the onset of economic data, which came out well below projections, the Shanghai composite has shed almost 45% of its value from its 52 week high in June 2015. In reaction to the severe market volatility, the People’s Bank of China has allowed a historic devaluation of the yuan (also known as the renmimbi) for the first time in 20 years. Due to this, Chinese investors have been anxious to get their capital out of China. Enter the EB-5 Program. In 1992, Congress created a visa program designed to stimulate economic activity and job growth, while allowing foreign nationals the opportunity to become U.S. citizens by investing and creating jobs in the U.S. This is known as the EB-5 immigrant investor program and has since grown to become one of the most popular vehicles for international investors to invest in U.S. real estate, with the vast majority most recently being wealthy Chinese. Per Real Capital Analytics cross-border capital data, while Canada remains the undisputed leading source of foreign investment capital, Chinese investors contributed $3.33 billion in foreign investment capital in U.S. CRE in 2014, the 4th highest that year, and is on track to contribute $6.89 billion in 2015. With an evolving China and the onset of foreign EB-5 capital and the rise and fall of the yuan, how will this change the landscape of CRE financing?
3) Divergence of Interest Rates - Mario Draghi and the EU
Germany, a major member of the European Union (EU), contributed $2.42 billion in foreign investment capital in U.S. CRE in 2014, the 5th highest that year. Additionally, while not members of the EU, Norway and Switzerland brought in $4.36 billion (2nd) and $2.31 billion (6th) of CRE investment capital, respectively. Collectively, these three eurozone countries invested almost three times as much foreign capital in domestic CRE than China. Across the pond, the EU potentially faces a make-or-break year as a multitude of factors bear down on both the health of the still struggling economy and the unity and cohesion of the Union itself. The European Central Bank (ECB), led by President Mario Draghi, continues quantitative easing (QE) - creating money to buy financial assets - by buying approximately €1.1 trillion of government bonds in the secondary market in an effort to spur inflation and, effectively, the European economy. Historically, QE programs have been credited with saving various major world economies – the U.S., U.K., and Japan - during the last economic downturn and preventing full-blown economic depressions. This year, economists will be keeping an eye out for whether Draghi and the ECB plans to continue or reshape QE and how it will affect the European economy.
Last year, the sanctity of EU unity was called into question during the continuing onset of the European sovereign debt crisis, in particular, the crisis in Greece also referred to as “Grexit”. This year, all eyes will be on the United Kingdom as “Brexit” threatens the EU. While near economic collapse is not the driving factor for the U.K., following the sweeping 2015 elections that nearly saw the secession of Scotland from the U.K., the question of inclusion within the EU is being put up for yet another referendum. As a major economic and political player, how would the potential exit of the U.K. influence capital flow into the U.S.? Finally, due to the continued divergence of central bank interest rates by the Fed and the ECB, which is leading to the U.S. dollar seeing continued value growth and the euro seeing further devaluation, this may lead to a historic occurrence – the parity of the dollar and the euro. What does that mean for domestic CRE and how will the events across the pond effect the United States?
4) How low can it go? - OPEC, Saudi Arabia, and the Re-Entry of Iran
Creating headlining news, seemingly every other day now, is the continued freefall of oil. Saudi Arabia has been relentless in its strategy to regain market share, at the expense of the U.S. and other OPEC members. With factions in OPEC calling for an end to the global supply glut, the re-entry of Iran into the fray, and the reignited conflict between Iran and Saudi Arabia, it is critical to consider how these global events will effect U.S. CRE. Research data has since shown a trend across all CRE asset classes. The obvious conclusion is that the trend is in decline in oil-dependent areas, as many of those headlining news articles have narrated. However, when considering other potential trends, will we see U.S. consumers pay less at the pump and increase discretionary income? Will we see a reversal, as many economists project will happen later this year? And finally, how substantive will these trends be in the long run? A former university professor of mine once lectured on the transformation of entire city skylines based on the price of oil. Here, we will inquire into the factors that will fuel that transformation.
5) Financial Contagion in East Asia – Singapore, Japan, and South Korea
Some of us may remember the Asian financial crisis of 1997 – the collapse of various Asian currencies and the spread of financial contagion throughout East Asia. With the historic devaluation of the yuan and the potential economic implications of China on the entire region, there is a concern that there will be a reprise of the Asian financial crisis for the currencies of nearby countries. Japan contributed $3.59 billion (3rd) in foreign investment capital in U.S. CRE in 2014, Singapore contributing $1.74 billion (8th), and South Korea contributing $912 million (unranked) for a combined total of $6.24 billion in foreign investment capital in U.S. CRE. These three major sources of capital flow were among the most seriously affected countries in 1997 which started with the devaluation of the Thai bhat and subsequently spread to neighboring countries. More recently, the Chinese government historically allowed the yuan to devalue and, following that action, the Singaporean dollar fell to multiyear lows, the South Korean won fell nearly 2% against the U.S. dollar, and the Japanese yen continued its fall to a low of approximately 17% against the yuan since early 2014. How will further devaluation of these currencies effect capital flow into U.S. CRE? Are these countries dogs or cash cows? Will this be a reprise of the Asian financial crisis?