There has been no shortage of volatility to start 2016. Amid dramatic sell-offs in global equities, commodities and emerging market currencies, financial markets have opened with a collective thud.
Causes cited for the instability include fears of oil oversupply, worries over the effectiveness of monetary policy and concerns over a China-led slowdown. However, a confluence of events, outlined below, may lead to another year in which US commercial real estate holds up well relative to other markets.
λ Further US dollar appreciation equals added return for international investors. The US is one of the few countries that has begun to normalise monetary policy. US 10-year government rates are higher than similar maturity rates in Canada, the UK, France, Germany, Italy and Spain – to name but a few countries. To the extent that higher government yields in the US support further dollar strength, particularly relative to currencies at risk of further devaluations, such as China’s yuan, the currency impact of an investment in the US can provide an added source of return for overseas investors.
Dollar strength has been associated with a rise in overseas investment in US real estate; alongside a nearly 20% appreciation of the dollar on an inflation-adjusted basis against its major trading partners since 2009.
Cross-border investors have gone from being net sellers of commercial real estate to accounting for more than 11% of all real estate activity in 2015, according to RCA.
λ Real estate’s illiquidity may be a positive. The illiquid nature of most real estate investments means that when the sky is falling, real estate is at the bottom of the “sell” list. There are few automated platforms for matching buyers and sellers of commercial real estate, and the process of securing financing limits how quickly transactions can complete.
REITs are more stable relative to diversified equities during market downturns. An analysis of total returns for the FTSE NAREIT US Real Estate Index Series and the S&P 500 from January 1972 to December 2015 finds that S&P 500 monthly total returns were negative 38% of the time.
However, on those occasions where S&P returns were negative, the Equity REIT index performed worse than the S&P 500 just 31% of the time, implying that on a relative basis, REITs outperformed the S&P 500 more than two-thirds of the time during months where the overall equity market was down. While the S&P 500 returned more than 7,300% cumulatively over the aforementioned 44-year period, the NAREIT Equity REIT index returned almost double – 14,600%.
λ Taxation changes favour overseas investors. Commercial real estate in the US may also benefit from legislative changes that affect taxes due upon disposition. Qualified foreign pension funds will now be able to invest in real estate without facing a tax on gains upon sale (FIRPTA), while foreign entities will be able to increase their holdings from 5% to 10% before triggering the FIRPTA tax.
λ US index investors may need to rebalance. Equity index and sector-specific funds may need to boost their investment in REITs to become more aligned with the composition of the overall index.
For the first time since MSCI and Standard & Poor’s developed the Global Industry Classification Standard in 1999, a new sector will be created: real estate is being moved out from its current industry group – Financials – at the end of August 2016 and will be classified in a newly-created Real Estate sector.
Does all of this point to continued acceleration in commercial real estate activity? Not necessarily, although there has been little slowing of net income growth on a per sq ft basis – a metric that has moved steadily upward as cap rates have declined. Risks include the potential for a tightening of underwriting standards and cap rates that are “priced to perfection.” But even if US commercial real estate were to weaken, chances are the sector will still outperform most investment alternatives in the coming months.
Heidi Learner, chief economist, Savills Studley
