A not-so-slow season

The shifts charted in this month’s macro deck require real estate investors to take a view on conflicting signals: Lower interest rates (driving values up) and slowing economic growth (driving values down). Optimism about future economic growth has declined due to elevated uncertainty, which delays investments and erodes trade activity and manufacturing (p. 8 and 25). This leads investors to take a risk-off stance, causing interest rates to decline around the world. Meanwhile, Central Bankers don’t have much room to maneuver, with rates already low and balance sheets loaded up through QE (p.23). The result has been a deepening of negative interest rates in Germany, France, the Netherlands, and Japan. Also this summer the UK, Canada and the US joined the yield inversion club. Historically, inverted yield curves are a signal of slowing economic growth in the next 12-18 months [see p. 4 and 11 for analysis of how inverted yield curves have predicted future economic activity].

For real estate investors, lower long-term interest rates imply lower borrowing rates, lower discount rates, and higher values. Slower economic growth, however, leads to uncertainty around future cash flows, raising the risk premium assigned to real estate and lowering forecast cash flows in a valuation model. The direction of real estate values will be based on the conflicting forces of lower base rates, higher risk premiums, and lower future cash flows.

So where are investors coming out today on these factors that push and pull on valuations? Borrowing costs are falling, but real estate prices do not price every shift in interest rates. Economic outlooks are lower; each investor takes a different view on how that will impact property cash flows. And there has not been a significant widening of CMBS, REIT Bond, or corporate bond spreads that would indicate risk premiums moving higher (p. 21).

The REIT market is showing value creation from lower interest rates rather than value loss from lower cash flow or higher risk spreads (p. 20). Anecdotal evidence supports private equity indices that show real estate values are flat to slightly higher this year in many countries. There are exceptions such as retail properties in many markets; and investors are becoming more selective in what qualifies as “core”, thus raising the risk premium on some properties. Given the time it takes to complete large real estate transactions, recent evidence is hard to come by; but as we move through a season of more active real estate trading, we should have a clearer answer in the next several months.

Interest Rates and Inversions are not the only topics discussed in the corridors of LaSalle and prompting emails to bounce around our firm:

• WeWork is moving closer to its IPO. Several commentators speculated how much magic this unicorn can bring to a market where some recent IPOs have not been well received (see p. 16-17). Information from the Prospectus has raised more questions than answers regarding the future of the company.
• The Larry Summers and Anna Stansbury piece about the eroding power of Central Bankers to guide the economy returns us to questions of Secular Stagnation and what it would take to really invigorate the global economy. These debates raise questions about the long-term outlook for real estate relative to other asset classes.
• Shopping center distress remains in the news, and we are trying to figure out which retail assets have value and where the islands of safety might be.