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Wednesday, December 12, 2012

Real Estate’s Correlation to Bonds

By: Amy Erixon (Toronto)

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?

Wednesday, December 5, 2012

Energy Fuels Houston's Real Estate Market

By:   Rand Stephens and Jeannie Roberts

Houston gained national attention in 2012 due to its economic vitality and strong job growth.  Driven by the oil and gas industry, Houston left the recession behind and turned its attention towards expansion, development, and acquisition.  Construction activity has substantially increased as developers address the pent up demand brought on by the economic downturn.  While Houston continues to stand out due to its economic environment, in 2012 the city also gained recognition as a desirable place to live.  Forbes ranked Houston as the Coolest City in America due to its cultural diversity and young workforce.  The International Energy Agency projects that the U.S. will overtake Saudi Arabia as the world’s top oil producer, and Houston is poised to take advantage of the oil boom in 2013 and beyond.  This will result in continued job creation and strong market fundamentals in the Energy Capital of the World.
Leasing activity in Houston’s office market picked up in 2012 with the continued expansion in the energy sector.  With rental rates on an upward trend and vacancy rates reaching the single digits in key submarkets, developers were quick to regain their pre-recession bullish approach.  3.9 million square feet (msf) of office space is under construction, with 3.1 msf delivering by the end of 2013.  45% of the construction is taking place in West Houston where the energy industry is concentrated.  The demand for new development is largely driven by tenants moving out of older buildings in an effort to retain a talented workforce and consolidate into efficient space.  A number of mergers and acquisitions within the energy industry are projected to occur in 2013.  Although this creates uncertainty in the office market, Houston will most likely benefit as most companies are expected to consolidate within Houston.
The industrial market witnessed significant space gains during 2012.  Strong demand and moderate development have led to a tightening industrial market, a trend that is likely to persist throughout 2013.  In an effort to find quality land, developers are expanding further north and west.  As drilling activity picks up, Houston’s industrial market can expect to see an increase in manufacturing volume, particularly in oil field equipment.  In anticipation of the Panama Canal expansion in 2014, the Port of Houston is making $206 million in capital improvements this year.  The industrial market is projected to benefit from this increased activity, resulting in increasing rental rates and decreasing vacancy through 2013. 
The retail market accounts for roughly $165 billion of Houston’s gross metropolitan product.  While retail jobs in most major metro areas have yet to recover, Texas created 24,500 retail jobs between August 2011 and August 2012.  Houston’s growing population is fueling the retail market, resulting in new development, particularly in West Houston.  Vacancy in the retail market is expected to decrease in 2013 as tenants capitalize on the renewed consumer confidence.
Driven by the energy industry, Houston has long been characterized by its boom and bust cycles.  However, the city’s focus on diversification in the past decade has led to a stable and growing economy.  Investors, both foreign and domestic, demonstrated their renewed confidence in Houston with record-breaking transactions in 2011 and 2012.  The Hess Tower sold for a record $524 per square foot in 2011, while the Shell Plaza Towers sold for a record $550 million in 2012.   High-profile assets, such as the Williams Tower and the Kinder Morgan building, have returned to the market in 2012.  As Houston continues to stand out among other major metropolitan areas, the city is projected to gain increasing amounts of investor interest.

Monday, December 3, 2012

Virginia Incentive and Assistance Programs for Startups and Business Expansion

By Dan Gonzalez (Washington DC Metro)

To support a pro-business environment, Virginia offers many incentives to startups and to assist in business growth. These incentives include financial assistance, facilities development grants, tax credits, and exemptions.
In particular, The Virginia Jobs Investment Program (VJIP) is one of Virginia's most actively used and popular economic development incentives. The program encourages the expansion of existing businesses and startups in finding and developing skilled workforces.  It also helps offset recruiting and training costs incurred by companies that are either creating new jobs or implementing technological upgrades. 

In addition, Virginia law currently provides a 100 percent capital gains tax exclusion for founders of, and investors in, high technology start-up companies located in Virginia.
According the the Virginia Economic Development Partnership (, the following are state programs offering incentives and assistance to startups and expanding firms: 

Virginia Investment Partnership Act

The Virginia Investment Partnership (VIP) Grant and the Major Eligible Employer Grant (MEE) are discretionary performance incentives designed to encourage continued capital investment by Virginia companies, resulting in added capacity, modernization, increased productivity, or the creation, development and utilization of advanced technology.

Virginia Small Business Financing Authority (VSBFA)

VSBFA offers programs to provide businesses with access to capital needed for growth and expansion.
Enterprise Zones

Virginia's Enterprise Zone program provides state and local incentives to businesses that invest and create jobs within Virginia's enterprise zones, which are located throughout the state.

Technology Zones

Virginia authorizes its communities to establish technology zones to encourage growth in targeted industries. Presently, 27 cities and counties and 3 towns have created zones throughout the state.

Center for Innovative Technology
CIT helps grow Virginia’s technology industry. Its CIT Entrepreneur program provides up to $100,000 in funding for promising high-growth technology companies and helps owners identify potential equity investors.”

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