EUROPE GUEST COMMENTARY: The Economist's Perspective

Real estate investors, particularly long-term core investors, are looking for stable, visible reliable cash-flows. Unfortunately, we live in times of heightened macro-political risk where underwriting real estate investments has become far more complicated than a simple assessment of local supply and demand conditions.

There are many geopolitical factors that one could describe as currently concerning, and in order of ascending importance, here are a few of the major factors to consider. First we have the sharp and sustained fall in global energy prices. This has had a profound effect on current inflation rates, exacerbating already profound deflationary forces at work in the global economy. Its impact on real estate is both positive and negative. More positively, cheap petrol prices are one factor stimulating consumer spending in developed markets in the US and Europe, offsetting the malign influence of weak to no income growth. What’s harder to gauge is whether cheap oil, if sustained, could impede capital flows from oil-producing sovereigns into real estate. So far, our experience is that there is still plenty of family office capital looking at our region. A more pronounced negative impact has been on the ability of our industry to generate the nominal absolute returns promised to investors in an era when we could usefully rely on getting 2 percent to 3 percentage points from inflation.

The second issue is China. China is the first emerging market to mature at scale, and its rebalancing from industrial exports to domestic consumer demand is resulting in both a hard and soft landing at once, depending on which region you are in. To be sure, there’s plenty of hardship in the north-eastern heavy industrial regions. But we are still seeing fast growth rates in the central regions that form the gateway to China’s west. Another complicating factor is that China is slowing, maturing and rebalancing at the same time as it is opening up its financial markets. This is causing marked volatility, particularly in its equity market, and that in turn is injecting volatility in global equity markets.

The third issue is the one that really keeps me awake at night, and that’s negative interest rate policy (NIRP) – or the idea that central banks in Japan, the Eurozone and other major markets have done so much to pump liquidity in the system and lower interest rates that they have got nowhere left to turn but to cut rates into negative territory. What worries me about this is two things. First, insofar as it signals that monetary policy has reached its limits, what happens when the next exogenous shock occurs? The second problem is that NIRP makes it hard for commercial banks to be in business. At the most simple level, banks make money by borrowing short and lending short. Central banks are now creating very flat yield curves with short term bonds often at sub 1 percent. That and new regulations makes it harder for commercial banks to be an effective mechanism to pass on central bank easing to consumer and commercial borrowers.

NIRP has also exacerbated the flow of capital from fixed income markets into real estate, looking for an attractive yield. This is, of course, great for the increasing depth and maturity of our industry. But it’s also setting the marginal price for assets with reliable income streams. Yields are being pushed into historically unprecedented territory and it becomes correspondingly harder to assess where the exit cap rate will be in five or ten years’ time. Because to do that, you have to have a view of whether fixed income markets will have normalized.

The final issue is the increase in populism globally. I won’t dwell too much here on the specific issues. Suffice to say that, from a European perspective, these issues make it harder to assess whether hitherto successful supply-side reform policies in some European markets will be adhered to, and make effective currency hedging harder and more expensive.

To be sure, the macro-economic medium-term forecasts for the major global markets are pretty benign. The problem is that the attendant risks around these benign forecasts are high, multifarious and, in some cases, historically unprecedented. Accordingly, those of us investing in real estate need to be even more aware than normal about the uncertainties inherent in real estate forecasting, while also building some cycle-awareness, or cycle-resistance into our underwriting.