The annual conference announced 'Real Estate's Time in the Sun', but forecasts were for a mixed outlook. Richard Lowe reports.
San Francisco was a fitting destination for AFIRE's annual membership meeting, which had been given the tagline 'Real Estate's Time in the Sun'. It is one of a number of cities leading a recovery in the office market, boosted by a booming technology industry, much of which has migrated from Silicon Valley in recent years.
San Francisco certainly provided a sunny backdrop, but the weather was changeable – at times very windy – while overhead the famous 'fog' would occasionally pass by, obscuring the sun. These could have been reminders that the outlook for real estate in US is not completely clear.
The event's opening keynote speaker, Jacques Gordon, global investment strategist at LaSalle Investment Management, also ran with the metaphor, advising investors to remember to bring their sun block. Markets, like San Francisco, were getting "hot", not so much because of property fundamentals and an improving economy, but because of the weight of capital moving into real estate.
"The capital flows to real estate in the first half of this year were incredibly strong," he said. "And the big question is: how will they react to the rising interest rates?"
Next week's announcement by the Federal Reserve, as to whether it will begin to phase out its quantitative easing (QE) programme, will play a pivotal role. Economist David Hale, speaking on the second day of the conference, put the odds on Ben Bernanke beginning to taper QE this month at 51%, although he said he expected rates to remain low well into 2015 and possibly 2016. Once the decision has been made, bond markets can move on, he said.
The question for AFIRE's members was how real estate would 'move on' after the announcement. The general consensus in San Francisco was that much of the 'cushion' – the spread between real estate cap rates and bond yields – had been eroded, but was still in a relatively attractive position. Bond yields would need to rise significantly – in the region of 3.5-4% – before asset allocators would begin to shirk real estate.
Gordon said as long as US Treasuries remained in the range of 2.8-3.2% and the real estate spread remained at around its long-term average of 300 basis points, real estate would remain "fair value".
The other advantage real estate has is its ability to benefit from a strengthening economy. The cushion between real estate yields and BAA-rated corporate bonds has also gone. But Gordon said property, unlike bonds, can look forward to rental growth.
"That means we're pretty much, just about, at fair value or slightly higher than fair value relative to the BAA bond," he said.
"Keeping in mind that the BAA bond is a coupon – it can't move and is sitting there based on corporate credit – and our yields should be able to move up in a rising economy, we are at fair value. We are not tremendous value – we're fair value."
Damien Manolis, managing director at Pramerica Real Estate Investors (known as Prudential Real Estate Investors in the US), offered a similar analysis during a discussion panel. "As interest rates rise, that is an indicator of the strength of the economy," he said. "So, on one hand, we are going to absorb costs from an interest-rate standpoint, but, on the other hand, we should be rewarded in terms of rent growth."
Todd Henderson, head of real estate for the Americas at Deutsche Asset & Wealth Management, said the effects of economic growth and rising interest rates on total returns in property were asymmetric. A recent study by Deutsche AWM found that a 1% increase in interest rates could reduce total returns by 2%, but a 1% increase in economic growth could boost returns by more than 5%.
But what if interest rates do rise above 3.5%? "There is a non-consensus view that would say we're headed for 3.5-4% 10-year Treasuries, and the corporate bonds rate would mirror that," Gordon said. "We would be moving ourselves into a situation where our yields are no longer sufficient to attract capital."
Gordon said this might be positive for the "long-term health of our asset" in the sense it would "reduce the capital pressure on real estate". But it would also be "painful" in the short term and could lead to a pricing "standoff" between buyers and sellers that would be unhealthy for the market.
But the general chatter in San Francisco suggested the likelihood of such a scenario was very unlikely. Either that or delegates simply found the idea too unsavoury to seriously entertain.
But there is another decision that could influence the US real estate market. And, as with monetary policy, it will be made by people whose main focus is not real estate.
AFIRE provided its latest update on the ongoing saga around the Foreign Investment in Real Property Act (FIRPTA), which has for some time, through tax measures, set a high hurdle for foreign real estate investors.
Speaking from the audience, Michael Catford, vice-president for real estate investments at the Healthcare of Ontario Pension Plan (HOOPP), said FIRPTA remained an impediment for the Canadian institution. "The tax regime for us is a difficult one to deal with," he said. "In order for us to be effectively neutral, we have to have much higher returns out of the US than in other countries. So that really is a dilemma we have to get over, but we do like the direction of the [market] fundamentals."
According to an update by Ryan McCormick, vice-president and counsel at the Real Estate Roundtable, the organisation lobbying to reform FIRPTA, lawmakers "came one step closer" in the summer through the introduction of a new bill on investment and jobs.
AFIRE chief executive Jim Fettgater explained that 30 senators and 60 members of the House of Representatives were co-sponsoring the bill. "So, it's got some momentum," he said. "Probably better looking today than it has been in the past several years."
He added: "This legislation has as good a shot as any I've seen in 30 years."