Just seven years after property portfolios lost roughly half their value, new high watermarks for individual assets are being achieved in Berlin, Hong Kong, London, New York, Paris, San Francisco, Shanghai and many other cities in 2015. All year long, investors have been asking, “Where are we in the cycle?” fearing that the end is at hand. Yet, as each month passes, prices continue to levitate. Highly accommodative central bank policies have not been successful in jump-starting broad economic growth; but there is no question that they have helped boost prices across a wide range of financial assets, including real estate.
Meanwhile, the global economic environment and the financial markets are both looking more fragile in the last two months. Eroding confidence in the securities markets (falling stock indices and rising credit spreads) have not yet translated into measurable, immediate impacts on the cash flows generated by real estate. However, investor sentiment has clearly shifted and gradual weakening of underlying fundamentals is now a heightened concern in many countries.
The irony of all this is that the pricing of income-generating real estate holds up well in this low-low-low world (growth-inflation-interest rates). Real estate income streams are way down the list in the chain reaction that occurs when growth slows and risk taking becomes constrained. A ‘lower for longer’ interest rate environment brings more cash into spread assets (like commercial property) as long as income-earning real estate can provide significantly higher yields than government or investment-grade bonds. And this spread is still present in all the major markets around the world today. Nevertheless, there are many ways that this spread can be eroded, including rising prices.
Three cycles, not one
Investors need to understand that there is not one real estate cycle, but three. First is the interest rate or credit cycle, which takes its cues from the broader capital markets, including the health of financial institutions and the actions of central banks. Second is the business cycle, which is driven by private enterprise, risk taking, household income and job generation. Third is the property cycle itself, driven by the specific supply-demand fundamentals in a particular market. Rarely, if ever, are all three cycles operating in perfect synchronicity.
Wise investors realize that different real estate styles do best at different stages of these three cycles. They also realize that secular trends will eventually trump cyclical changes and that predicting an exact turning point in any of these cycles is difficult, if not impossible. So, one way to frame an investment strategy for 2016 is to simply think through which assets, programs, funds and debt strategies will excel at each stage of these three cycles, and then place each part of an investment portfolio in ‘out-perform,’ ‘neutral,’ or ‘under-perform’ categories, based on different cycle scenarios.
For example, a long duration lease strategy that relies on low cap rates to succeed will under-perform in a rising interest rate environment, but could out-perform if ‘lower for longer’ continues for several more years and the value of defensive income rises. Leasing and development strategies are a good hedge for the rising interest rate/faster growth scenario, but they may struggle if ‘lower for longer’ is accompanied by sub-standard growth in the business cycle. Finally, a market-specific play on development or leasing can be put at risk by an over-eager supply response, even if the business cycle and the credit cycle are cooperating. So, the micro drivers of the property cycle have to align with the more macro drivers of the capital markets and the business cycle.
Although it is dangerous to generalize across entire countries, it is clear that interest rates are at a cyclical low and the capital markets are further along in their cyclical recovery, relative to either the business cycle or property market fundamentals. This situation has been in place in many developed countries for three or four years, and could continue for several years more. Inflation is running below 1 percent and no central bank is in a hurry to raise rates rapidly, given the tepid pace of global growth. In sum, the wise investor does not count on market-timing to drive their overall portfolio performance, but relies on balancing different strategies, all of which will work together regardless of the scenario produced by the big three cycles of real estate.