Last week the annual
Canadian Real Estate Forum was held in Toronto. The topics from two of my recent blogs were
widely discussed: 1) soft or hard
landing for the topping condo market, and 2) the relationship of commercial
real estate pricing and interest rates.
My April, 2011 blog
documented the fact that over the past 50 years in the US commercial property market,
interest rate changes affect who buys, (leveraged buyers enjoy a
temporary cost of capital advantage) but have not had a strong influence on actual property pricing. Perhaps this is because interest rates are
traditionally lowered when economic prospects are poor. Logic follows that a weak economy should
lower property values as underwritings become more conservative in terms of
rollovers, rent growth, costs and vacancy allowances. We are recently observing a period where,
since 2001, interest rates have been very low, and generally declining, and so
have cap rates. Globally, this created
an atmosphere of increasing use of leverage on investments to maintain net
returns near historical averages.
Interest rates are currently at unprecedented low levels to support anemic
economic growth. Meanwhile, residential
and commercial property prices, which in Canada did not correct much in 2008
and 2009, are simply going higher and higher.
The consensus of Toronto conference
participants was that property prices will continue to go higher until rising
interest rates bring them down. Given
the amount of new capital being allocated to real estate these days, I am not
convinced that within reason, higher interest rates will not have an immediate
or direct manifestation into lower prices, there are a lot of factors to
consider.
To justify that real
estate pricing is not in a bubble, many point to the spread between real estate
cap rates and treasuries (or Government of Canada Bonds). We will unpack this in a moment, but recently
key industry leaders have begun to assert that property is, in fact, being priced
off the bond market, and that their
clients think it should be. This is nonsense. Investors still use long term models to
acquire real estate. Mortgages may be
priced off the bond market. But, the key
attributes that investors seek from property investments in a multi-asset class
portfolio are a low correlation to
stocks and bonds, and a long term
inflation hedge, neither of which would be served using this benchmark.
A better understanding
of current market conditions is that many asset classes are moving in sync and
this is not what we would usually see (think gold and stocks in 2011). Allocations investors make to various asset
classes are influenced by relative risk and return expectations, diversification
goals and other considerations, such as indexing of benefits. Market pricing is a result of supply and
demand for assets, which draws from a broad array of factors. A lot
of what we have been seeing is really a flight to quality, and defensive
investing, across all asset classes. Any
value manager can tell you a much better indicator of absolute pricing for real
estate than bond yields is discount or premium to replacement cost. I am surprised to hear managers suggest their
positive portfolio performance is simply a result of quantitative easing and
will quickly be erased when that easing is withdrawn. We all
want to think that our good work, supply discipline, stock selection and asset
management skills matter more.
What in fact has been
happening is far more complex than a snapshot look at the spread to government
bonds. Investor demand for property is
rising. Real estate has been producing
relatively stable income characteristics, even in countries where valuations have
swung violently over the past 5 years. Corporate and individual user preferences are
shifting. Energy efficiency, transit
oriented locations and mixed use developments are growing in appeal, and prices
are being bid up for these kinds of investments. Beyond a defensive flight to quality (which
is also happening), rents in state-of-the-art well located assets are pulling
away from those in older stock with bloated operating costs and functional
obsolescence. These shifts are
translating into weaker demand and lower pricing for generic assets at the
fringes of markets and rising prices for best in class assets. On
average prices may have not increased as much as it might appear due to the
prominence of headlines announcing new pricing records in gateway markets
throughout the world.
Defensive investors
have been loading up on property company stocks, REITs and where they can,
direct investments, including condominiums as rental properties. Cheap and available mortgages are allowing
investors broad access to property markets in scale. This surge in debt and equity capital is
driving up prices, particularly for best in class assets. In Canada much of this allocation shift is
coming out of the bond market where returns are far below actuarial
requirements, and credit quality has deteriorated. I
believe that people are confusing rising prices resulting from rising demand
for income products with leverage fueled asset price expansion, although we may
be seeing some effect from both.
There is no question however,
that the housing market is highly sensitive to interest rate shifts. A
glance at the chill created in Canadian markets by simply changing allowed
amortization lengths underscores this. This may magnify our impressions of the impact
leverage is having, as most of us are homeowners, and it affects us directly in
the pocketbook. The longer these very
low rates stay in effect, the more “baked-in” to the economy they become, and
the more difficult they will be to increase, especially for housing.
The real question for
us to be asking is how sticky is the current allocation surge toward
property? Does this constitute a
rethinking by the market of the fundamental value proposition offered by
traditional asset classes, such as stocks and bonds, and does such a shift have
staying power?
