Conversations in Boston this week were more often than not about forecasts. Spring officially began on Thursday, but the most persistently cold winter in recent memory was showing no signs of ending its outstayed welcome.
The day before, the new chairman of the Federal Reserve Janet Yellen gave her first press conference. Everyone was hoping that the average temperature on the East Coast of America was going to rise more steeply and swiftly than the 10-year Treasury. Yellen’s admission that short-term rate hikes could begin in six months’ time did little to improve hopes.
The issue of rising interest rates has been causing anxiety among the institutional real estate industry in the US for almost a year now, and it continued to feature throughout panel discussions at PREA’s (optimistically titled) Spring Conference.
Rising interest rates threaten to dampen real estate returns as the cost of debt increases and the yield spread between property and government bonds is squeezed. The main source of reassurance is that sufficiently strong economic growth (a pre-requisite for QE tapering) should lead to net-operating income growth (NOI). In other words, rental growth should offset the negative effects of rising interest rates to sustain attractive returns in the asset class.
Martha Peyton, head of strategy and research at TIAA-CREF, said: ’The question that’s most relevant isn’t really what’s going to happen to interest rates but why. What the Fed is telling us is that they will not allow interest rates to rise unless the economy is strong enough to withstand it. That means an awful lot to prospects for NOI growth.”
Of course, investors need to find the right investments that will benefit from this story. Buying prime property at very low yields today could be a vulnerable strategy.
Peyton said it could be a good year to “shed properties that have weaker NOI growth and reposition portfolios to really focus on where a strengthening economy is most likely to boost NOI growth.”
The consensus is that interest rates on the 10-year Treasuries are going to rise 3.5% in two years’ time. But a number of speakers voiced concerns that common expectations might be too conservative.
Jacques Gordon, global strategist at LaSalle Investment Management, readily admitted that it was impossible to predict the trajectory of interest rates, but he considered a 4% rate by 2016 a distinct possibility. Such a scenario would have significant implications for investments. “Certain kinds of real estate [would be] hammered,” he said. “Net-lease, bond-like deals – forget about it.”
Gordon remarked that QE was “distorting lens to all asset classes, real estate included”. He added: “So we do ourselves a disservice to say that the accommodative policy that’s in place today is going to slowly and easily unwind. It won’t be like that.”
Like Peyton, Gordon favoured investments that could benefit from NOI growth of more than 3%. His recommendation was to invest in assets that would could captalise on positive demographic, technology and urbanisation – increasingly known as DTU – trends. Rather than secondary and tertiary cities, Gordon preferred secondary locations in gateway cities where ‘Millennials’ are increasingly flocking.
Later that day, Edgar Alvarado, group head of real estate equity at Allstate Investments, said: “I was more in Jacques’ camp this morning.” He added: “Our house view is that we are going to be in the four-to-four-and-a-half range by 2016.”
Summing up one of the sessions, Steven LeBlanc, founding partner of CapRidge Partners and former head of private investments at Texas Teachers’ Retirement System, said: “What I’m hearing is there is a belief that we’re in a rising interest-rate environment, that the 10-year Treasury three-and-a-half to four-and-a-half, that spreads may compress, that core may be overvalued today and it’s better to move into a little bit more risky space.”
What was perhaps most significant were discussions among a number of US pension investors about now being a good time to sell core real estate. With such a large volume of capital expected to target the real estate markets in the near future and light of the above considerations it could be an apposite move.
A similar notion was discussed at MIPIM in France last week, suggesting 2014 could be a pivotal year for institutional allocations across the mature markets of North America and Europe. It is unlikely to be a reduction in overall allocations to real estate – these are for the most part on the rise – but it could take the form of a widespread rebalancing of portfolios and an opportunity to realise some profits.