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Wednesday, April 26, 2017

My take on the Trump Effect

 By Blake Thomas (Raleigh)  

For the business community, and more specifically the capital markets, 2017 began with a lot of optimism.

Much of this increase in market confidence could be attributed to the unprecedented November 2016 election of President Donald Trump and of Republican majorities on both sides of Congress. The decisive victories represented a drastic shift within the federal government, gave the Republicans a clear path to policy reform, and signaled to the world that the American people were tired of business as usual, or to be more precise, gridlock as usual, in Washington, DC. Trump’s agenda on the campaign trail and during his first few months in office has been focused on pro-business, pro-growth policies. The pillars of Trump’s Republican agenda have been centered around tax reform, a rollback of Obama-era regulations (specifically in the banking and healthcare sectors), increased defense and infrastructure spending (with corresponding cuts to entitlements and various government agencies), and revised trade policy (think: China and Mexico). The markets are now reflecting the potential impact of these policies as though reform is actually possible in Washington. But, to date, reform largely remains to be seen – outside of executive orders.

Market exuberance was evident immediately following the election results when the 10-year treasury (10-Yr UST) jumped to 2.063% on November 9 from 1.857% on November 8 – a 20.6-basis-point surge overnight. This increase in the long end of the yield curve was not driven by a massive selloff of this financial safe haven by global institutions due to some economic crisis or policy but, rather, a clear signal from investors of strong economic growth expectations.

Remember that nominal interest rates, like the 10-Yr UST yield, comprise two components: real interest and inflation, both of which are impacted by anticipated economic growth. Investors now have higher real interest rate expectations due to greater opportunity costs within the broader capital markets. Moreover, since the U.S. economy had been bouncing along the bottom for the last eight years with inflation below the Fed growth target of just 2%, it does not seem like a stretch to say that the market began suddenly pricing in higher inflation given the expectations for a faster-growing economy. More good economic news came within five days of President Trump’s inauguration, when the Dow Jones industrial average (Dow) crossed 20,000 for the first time in U.S. history. For all but a few days in late January since, the Dow has stayed above this historic mark, peaking at more than 21,000 on March 1. This equity market run-up enforces the notion that there are greater yielding opportunities for capital markets participants. And recently, another key economic indicator, the Conference Board’s U.S. consumer sentiment index, reached its highest level in 16 years.

But what do these gains mean for commercial real estate (CRE)? While the current administration is focused on promoting faster gains in the economy, there will be pluses and minuses for CRE – as well as winners and losers. Following the Reaganomics formula, tax reform should be a boon for overall economic growth by making the U.S. a more competitive environment for businesses in the global marketplace. Proposed corporate tax rate cuts should encourage companies to reinvest in their core businesses, providing additional job and wage growth as well as capital investments in plants and equipment. As such, tax reform is expected to help drive demand for CRE space and continued rent growth. However, along with these proposed tax reforms there have been discussions regarding the elimination of tax deferrals like 1031 exchanges – a move that would negatively impact CRE liquidity and affect all market participants and product types.

Rolling back banking regulations, such as the new risk retention rules of Dodd-Frank and Basil III, would increase liquidity and promote further investment and development in CRE. Although some might argue that, due to the increased regulations, fundamentals have remained in check and helped prolong this latest cycle. Infrastructure investment in roads, bridges and railroads should also provide a lift to CRE as long as commodity prices do not rise significantly due to increased demand for raw materials to support the new public works projects. This type of government spending is designed to not only address our nation’s aging and decaying infrastructure, but also to aid the president’s push to bring back manufacturing and provide additional higher-than-average paying jobs to the U.S. economy. Increased infrastructure investment and wage growth have the potential to bolster CRE values further.

The big question mark surrounds trade and immigration reform. More restrictive trade and immigration policies could undermine economic growth – with the industrial and retail real estate sectors having the most to lose. A near-term reduction in U.S. trade would likely reduce industrial space demand. Ultimately, domestic manufacturing would need to satisfy consumer demand for goods if imports fall. A reduction in imports could lead to wholesale changes in location demand as companies reconfigure supply chains and distribution for domestic fulfillment. The proposed border tax could increase the costs of retailer inventories through a tax on imports, though the U.S. dollar could strengthen and offset the impact.

In most cases, I believe that long-tenure, single-tenant net leased (STNL) retail and healthcare properties could see the smallest benefits from the current administration’s pro-growth policies due to fixed-rent escalations already embedded into pre-existing lease agreements. STNL retail and healthcare properties could even suffer valuation declines if stronger economic growth is accompanied by higher inflation and interest rates – a situation that could increase cap rate spreads and, ultimately, negatively impact reversion values.

In general, market confidence in CRE is warranted in the near term, with significant positive impacts to all product types expected. If some proposed pillars of the Republican agenda promoting wide-scale economic growth come to fruition, then office, industrial and multi-tenant retail properties should see continued healthy rent growth – a trend that would likely offset a cap-rate expansion. Tax reform already seems to have been priced into the markets, and if the administration is unable to push legislation through, a pullback in debt and equities will likely occur.

However, if tax reform is approved by Congress, then the CRE sector may see additional lift due to the removal of the uncertainty surrounding tax reform.

(Blake Thomas is a Vice-President with Avison Young’s capital markets team in Raleigh.)



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