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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?

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