Deep Dive: The downside to low interest rates

The global interest rate environment is in uncharted territory. Not only are rates at, or near, all-time lows in nearly every developed market, but they appear poised to remain there for the foreseeable future. They might even fall lower, as is the case for the US, in the face of modest economic expansion. The implications of this monetary ecosystem on real estate investment vary by perspective.

For capital seekers, both debt borrowers and equity managers, it is unquestionably a boon. Financing is cheap and accessible, and investor interest – already elevated thanks to the growing institutionalization of real estate – is amplified further by the asset class’s value relative to declining fixed income instruments and inflated equities markets.

Capital providers, such as pensions and insurers, face a more precarious reality. For them, lower rates mean lower returns – not only from treasuries and corporate bonds, but throughout their portfolios – making it harder to satisfy liabilities. Increasing real estate exposures can offset those diminished gains, particularly if rate cuts inflate property values and boost near-term performance. However, in the long run, the weight of increasing capital coupled with tepid rental growth does not bode well for commercial property returns.

“The downside today is with the high pricing in the real estate market, returns going forward look to be lower than historical averages,” Greg MacKinnon, director of research for the Pension Real Estate Association, a Connecticut-based trade association for institutional investors, tells PERE. “Given low interest rates, real estate will continue to be attractive relative to other asset classes. But the issue is once that capital targets real estate, where do you invest it?”

A growing demand for real estate is already evident. Last year, global transactions hit an all-time high of $800 billion, according to data collected by Chicago-based broker JLL, surpassing the previous record of $786 billion set in 2007. And, with between $700 billion and $1 trillion in dry powder targeting real estate at the onset of 2020, according to research compiled by Paris-based AXA Investment Managers, that record is poised for a short life.

Capital volume alone is no cause for concern. Absent are the telltale signs of an overheating market; leverage use remains moderate and, aside from certain subsectors – pockets of luxury condos and senior housing, for example – supply has not surpassed demand. But the more risk investors need to assume to achieve adequate returns, the harder it will be to keep both components in check. Also, as property yields decline, total returns will be more vulnerable to volatility. “The longer this carries on, the lower yields continue to go, the more susceptible the markets become to any movement thereafter,” Justin Curlow, global head of real assets research and strategy at AXA, says.

More broadly, central banks with interest rates near, or even below, zero percent have little recourse should another global recession strike. That, too, threatens commercial property owners. So, while the real estate industry stands to benefit from falling interest rates in the near term, the long-term costs remain to be seen, particularly if lower for longer becomes lower for forever, as some project.

Freefalling

Falling rates have been the norm in recent decades. The federal funds rate – the US Federal Reserve’s mechanism for steering monetary policy – has been on a downward trajectory since the early 1980s when it peaked above 19 percent. The 10-year treasury rate has followed a similar path, providing a steadily lower benchmark for investors to measure returns against.

Other leading economies, such as the UK, France and Germany have charted similar courses. Japan was an early adopter of ultra-low interest rates, settling near zero percent in the late 1990s, and occasionally dipping below it. Today, it sits a -0.1 percent, while Germany, the Netherlands and Switzerland also boast negative yielding sovereign debt.

Global rates, which had been stagnant since the global financial crisis, appear poised for a comeback in 2016 after the US Federal Reserve began ratcheting up its funds rate. However, last year, sensing weakness in the economy, the Fed reversed course. The rate is now at 1.5 percent, down from its post-GFC high of 2.4 percent. The UK sits at 0.78 percent, Spain at 0.43 percent, Sweden at 0.07 percent and France at 0.04 percent. Australia’s central bank began 2020 with its cash rate at a record low of 0.75 percent and plans to cut it at least once more before the end of the year.

Melissa Reagan, head of research in the Americas for Nuveen Real Estate, a London-based manager, tells PERE the decision to begin slashing rates again is an indication of how delicately central banks are approaching monetary policy in a such a flimsy economy. “Central banks globally have been worried about the world entering a recession and having no ability to further decrease rates,” she says. “They have carefully managed through the volatility we’ve seen in the past decade. You could argue the US economy went into a mini-recession in 2016, then another mini-recession in the beginning of 2019. Central banks saw all that and continued to maintain rates where they needed to because they were worried about going into a recession with no ammo left.”

The consensus among the more than a dozen managers, investors, bankers, economists and consultants interviewed for this article is that lower rates are here to stay for the foreseeable future. This has given managers a rosier outlook on returns, at least in the short term. AXA, for one, upgraded its return expectations in every major region for 2019 through 2021, increasing its projections by at least double in the US, UK and Japan, along with a roughly 30 percent bump in the Eurozone. Though up from previous forecasts, growth in each region is still below the rates achieved during the prior four years.

Curlow says the anticipated uptick is a response to a surge of new capital flooding into real estate. Indeed, globally, institutional investors are 110 basis points below the target allocation to the asset class, according to a survey released by the New York-based advisory firm Hodes Weill last fall. Curlow expects their increased activity to drive up property values. “The previous rising interest rate environment and its potential for real estate value decline has given way to even further compression in real estate yields, improving short term prospects.”

Yet, while cheap financing makes real estate more attainable, falling rates do not historically have a positive correlation with property performance, MacKinnon tells PERE. Rather, he explains, the sector thrives on the back of a booming economy when rates tend to be on the rise. Analysis from PREA shows that regardless of how quickly the US economy grew each year between 1978 and 2012, real estate produced better returns during years when 10-year treasury yields were on the upswing. In years of high GDP growth, average returns tracked by NCREIF were 10.6 percent in rising treasury years versus 10.2 percent when treasuries fell. Conversely, during periods of low growth, strengthening treasury years saw real estate returns of 8.1 percent compared with 5.4 percent when treasuries fell. Similarly, real estate had its best year post-crisis in 2015, when the NCREIF Property Index tracked a 13.33 percent annualized return as US GDP grew by 2.9 percent, despite steady low interest rates.

However, more recently, the relationship between GDP, interest rates and real estate has changed. In 2018, when the US economy grew by 2.9 percent and treasury yields increased by 25 basis points, the NPI ended the year with annualized growth of just 5.61 percent, a little more than half the average over the previous five years.

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Institutional capital is worried about the long-term impacts of ‘a global stage that we’ve never seen before.’ Anthony Breault of Oregon State Treasury, Greg MacKinnon of Pension Real Estate Association and Brant Bryan of Cresa tell us what a ‘lower-for-longer’ interest rate environment means for private real estate.

If the dynamics between the current economic expansion and the real estate industry are different from previous cycles, it is in part because this is a different kind of recovery, Lee Menifee, head of research for PGIM, a New Jersey-based manager, tells PERE. During the previous two growth cycles, expansion of developed economies was driven by higher productivity, thus allowing tenants to take on more space and pay more in rent. However, productivity gains throughout those markets have been relatively modest since 2011, according to PGIM research.

Instead, new hiring has accounted for roughly twice as much GDP growth as productivity during the past decade. This benefits real estate by keeping demand high for office space, spurring new household creation and enabling more consumption, but it has not led to the type of capital appreciation enjoyed by property owners in prior growth cycles. “The bad news for real estate is that rent gains are likely to be lower than they were in the past because tenants’ ability to pay requires them to be more productive,” Menifee says. “That impacts most sectors.”

Double duty

Despite the downward pressure on yields, investors are not shying away from real estate. In fact, more are growing their targeted exposures, hoping to make up for lackluster performances in their fixed income portfolios.

Of the 212 institutions surveyed for Hodes Weill’s 2019 Allocations Monitor report, 96 percent said they planned to invest in real estate last year, up 24 percent from 2014. Meanwhile, 23 percent said they would invest more capital into the asset class than they did in 2018. Many are below their target exposure to real estate as a result of the denominator effect, caused by soaring stock prices that have outpaced property appreciation.

Return expectations have not been dampened by this increased competition, even after returns fell in three out of the past four years. Respondents reported a year-over-year return rate of 8.8 percent in 2018, down from 11.8 percent in 2014. Overall, the survey participants reported an average expected return of 8.3 percent last year, with sovereign wealth funds eyeing closer to 10 percent.

“Real assets, and real estate in particular, have been popular because rates have been low and institutions need to generate yield in their portfolio,” says Meagan Nichols, global head of real assets for Cambridge Associates, a Boston-based consulting firm. “Because investors have needed to be creative about alternative sources of that income, we have not seen a slowdown in income-generative real estate strategies, even in a low rate environment. A theme we discuss with clients is: how are we going to continue to generate income? How are we going to continue to meet our return expectations?”

Ben Maslan, managing director of the Los Angeles-based advisory firm RCLCO, says his clients have favored direct investment into real estate over treasuries and corporate bonds, given the current interest rate market. Even low-yielding, core real estate offers better relative returns than fixed income products, which are hovering around 2 percent, he says, especially if the properties are levered.

However, Maslan says pensions may be pressed to find ways of extracting income from their real estate holdings to make up for the loss of capital appreciation in a sustained low interest rate environment, especially if the defined benefits that need to be paid out do not decline commensurately. “Just because we are in a low interest rate environment doesn’t necessarily mean the actuarial rate of return will decline,” he tells PERE. “The bogey remains the same, but you may have declining go-forward returns as the appreciation returns decline and as yields continue to compress.”

New norms

Japan has been ahead of the curve when it comes to falling interest rates and that is largely because it leads the developed world in another unenviable statistic: population decline. The east Asian nation has seen its birth rate since fall steadily since the late 1970s and in 2011 it dipped below replacement levels.

Interest rates in the country plummeted after the collapse of the its asset price bubble in the early 1990s and have yet to recover. Its 10-year bond still produces negative yields. Japan’s perpetual stagnation is catching on in Europe, where growth is similarly anemic. In a white paper released in January, JP Morgan’s chair of global research Joyce Chang argues the US is unlikely to experience “Japanization” in the near- to medium-term future, but treasury yields are likely to fall to zero during the next recession and remain there for an extended period. Should this shift take place, Shinji Kawano, head of overseas investment at Tokio Marine Asset Management, tells PERE that more investors will have to learn to live with systemically lower returns as he and his contemporaries did in Japan.

Despite a stagnant government bond market, cap rates on Japanese real estate have continued to compress over time, albeit modestly, Kawano says: “We learned that we should not stop investing.” That approach applies abroad as well, with Tokio Marine and other Japanese institutions showing a renewed interest in cross-border investment as their peers in Europe or North America currently focus more intently on their home markets, as per Hodes Weill’s Allocations Monitor. Kawano tells PERE a 5 percent return on a US open-end diversified core fund is attractive, even after losing 2 percent to hedging costs. “Our goal is to make our portfolio with dollar-cost averaging,” he says, “so we will not change the pace of investment or bet large amounts of money at one point.”

A slower for longer approach would not be the only paradigm shift for global investors to adapt to in a sustained low interest rate environment. Menifee says other fundamental shifts have changed how properties should be underwritten, including the trend toward offering more amenities and services. The hotelization of office and multifamily properties, for instance, requires greater capital expenditures to grow – or even maintain – attractive yields, which is an important caveat for investors seeking stable returns amid falling rates, he tells PERE.

“Real estate is being priced as a yield vehicle that is attractive when compared with yields from other asset classes,” Menifee says. “The risk around that is not understanding how durable those yields are. We have a lot of research that indicates real estate is becoming increasingly operational in nature, it’s less of a coupon-clipping, get-your-yield-without-putting-a-lot-of-money-in asset class. It requires more ongoing investment, both in terms of money and management expertise, which can erode returns over time.”

Similarly, AXA’s research indicates that as interest rates continue to tumble, yield spreads will be dictated by capital expenditure requirements. “Assuming real estate continues providing positive returns and doesn’t become the next asset class to go negative yielding, it is the cap ex requirements to retain the income generating nature of real estate that is going to provide a floor to how low property yields can go,” Curlow says. Low-touch assets such as self-storage figure to provide more stable returns than hotels or office properties.

Safety in specialization

In periods of declining rates, real estate returns are driven more by exit prices than rental growth, Curlow tells PERE, which puts greater pressure on asset selection. His firm is wary of assets highly exposed to the broader business cycle, including hotels, offices and certain retail properties.

Christoph Donner, chief executive of Allianz Real Estate of America, says the Munich-based insurer is seeking properties that stand to maintain rental growth and appreciation through a weak economy. Increasingly, he says, that means delving into niche property types. “We want to make sure real estate investments are tied to buildings with a unique purpose and we try to avoid investment in commodity buildings. We’re looking for assets with an attractiveness that goes beyond a shell for the operating business,” he says. “Medical office, lab space or student housing are components that can provide additional yield or protection against a change in the environment.”

Blackstone, the New York-based manager, is also taking a defensive approach to acquisitions in a low rate, low growth economy. Nadeem Meghji, head of real estate in the Americas, tells PERE the firm has done this through large-scale deals built around specialized convictions, including its $18.7 billion take-private of logistics specialist GLP’s US platform as well as its rash of resort purchases on the Las Vegas Strip. “Real estate values have increased given the global search for yield so you have to be selective today and focus on assets that will produce outsized cash flow growth over time.”

With a global economy struggling to find its way in the long wake of the GFC and myriad hazards threatening to topple an already-shaky geopolitical balance, central banks are poised to continue handling monetary policies with extreme caution. As such, interest rates will stay lower for longer. Whether that is a net positive or negative for the private real estate industry remains a debate. Undebatable is that the now widely-accepted paradigms brings its challenges to private real estate’s biggest capital and its stewards.

Low rates drive competition in European debt space

European banks are facing stiffer competition as non-traditional lenders capitalize on a demand for cheap debt.

With bond yields just above, or – in the case of Germany, the Netherlands and Switzerland – just below zero percent, capital has flocked to property markets as an alternative to fixed income investments. However, this ravenous demand paired with more restrictive banking standards has resulted in a surge in non-bank lenders.

“It’s not only the interest rates affecting the profitability of banks, but also the fact that there are many other sources of capital on the lending side that did not exist in Europe previously,” Emmanuel Verhoosel, global head of real estate and hospitality at Natixis, a Paris-based bank, tells PERE. “Aside from the debt capital market, there are also debt funds being developed which are new competition for banks and insurance companies in Europe. That all makes things more difficult.”

Last year, six European-focused real estate debt funds closed on a total of $3.9 billion, according to PERE data, the lowest total since 2012. However, 93 similar vehicles closed during the previous five years, accounting for $42 billion.

While falling interest rates have made it more difficult for banks to profit on mortgages, Verhoosel says Natixis has mitigated this disruption by focusing on fee-based services, such as mergers and acquisitions as well as debt capital markets activities. As banks face stricter limits on the amount of risk they can assume, other institutions other entities are filling the gap in the mezzanine debt space.

Similarly, Verhoosel sees borrowers expressing a greater risk tolerance to make up for dwindling returns. “With lower returns, we’re seeing some clients who are typical core investors pursuing value-add structures,” he says. “That’s a trend you can see, subtly for some, less subtly for others.”

Christian Schmid, a managing director for the German bank Helaba, has seen borrowing and recapitalizations increase as a result of the country’s negative bond yields. He has also observed borrowers migrate toward higher risk strategies, including allocations to non-core markets and investments in atypical property types, such as light industrial and hotels. “Both of these trends could also take a hit if the economy were to sour,” he tells PERE.

Competition and declining rates have led to slimmer margins for Helaba as well, though Schmid says his bank has been able to make up the difference thanks to long-term business relationships, expansion into the Spanish market and an ability to execute complex deals that earn a premium. “We pursue a strategy of targeted acquisition of new business with existing and experienced new customers with proven expertise,” he says. “We adhere to financing parameters that have been resilient for years and stabilize the loan portfolio by actively managing it and expanding our business with savings banks.”