US National elections and the approaching ‘fiscal cliff’ make it difficult to devise investment strategies, finds Stephanie Schwartz Driver
Although the fundamentals for US real estate are looking stronger than they have since the onset of the financial crisis, global fiscal uncertainty and the lead-up to November’s national elections have been challenging investors.
The year started buoyantly, with expectations of job growth and economic growth brightening the outlook for institutional investors. And while joblessness has declined in September to its lowest level (7.8%) since January 2009 – when President Barack Obama took office – economic growth has been slower than expected. In the second quarter of 2012, economic expansion slowed to only 1.3%, significantly lower than the long-term average growth rate of 3.3%. 0
Although growth is slower than had been hoped, the economic news is not all gloomy. Manufacturing and retail sales both grew in the second quarter and home sales were on the rise, as some of the shadow inventory starts to clear and homebuyers feel more confident that the market has finally hit bottom.
The looming concern in the short term is the ‘fiscal cliff’: the scheduled end to many tax cuts and the start of new taxes associated with the new healthcare law, as well as spending cuts agreed as part of political negotiations in 2011 to forestall a budget crisis. Although these measures are projected to cut the deficit in half, it is also likely that the US would again fall into economic recession.
“We were recognising the fiscal cliff at the beginning of the year as a reason for caution in the US,” says Mark Roberts, global head of research and strategy at RREEF Real Estate. “If the US Congress does not implement some revisions, then it could severely limit growth in the US in 2013. But, for now, the housing market is improving and businesses are in better shape than they have been in some time, which should underpin growth in the US.”
Uncertainty about the fiscal cliff is one factor keeping investors on the sidelines, according to Jack Chandler, global head of real estate at BlackRock. “We have seen a marked slowdown in everything related to real estate in the last month or so,” he says. “A lot of people are waiting and seeing, deferring decisions as long as they can.”
This is true not just in the real estate market. The non-partisan Congressional Budget Office, which has been vehement in its warnings about the prospects of economic disaster if the US passes over the fiscal cliff, pointed out that the economy overall is already being “held back” as businesses in all sectors hold off on investment decisions because of uncertainty.
“It is an easy time for real estate investors to outrun the pack, but we do not see a lot of people trying to do that,” Chandler says. “You could be bold and take a view that in 2013 major employers will add to employment, that consumer confidence would increase. You could say that increased business activity will drive more activity to hotels. There are many theses you could say you believe in. But there is not a lot of high conviction on many investment ideas.”
Investors are also stymied by long-term bond yields under 2%. “Nobody’s business model works, and investors are struggling to figure out what to do” to find capital preservation, growth and some yield, Chandler says. “There is some interest in the real estate space for yield, but the general level of activity is low.” He expects this will remain the case through the elections in November and as the country approaches the fiscal cliff at the end of the year.
The high initial yields on real estate relative to low bond yields could indicate good relative value for real estate ahead, Roberts says. With cap rates around 6%, compared with treasury yields under 2%, real estate looks pretty attractive. And, Roberts notes, “there have been very few times in the past when the split between cap rates and treasury yields was as wide as it is today.” When this occurred in the past, real estate total returns usually exceeded their average of 8% over the subsequent three to five years.
RREEF sees opportunities in the debt markets, according to Roberts. In his view, there is a reason why yield spreads are wide, and one of the factors may lower lending volumes compared with the past. The commercial mortgage-backed securities (CMBS) market has not come back, so there is a lending gap that is creating reasonably good risk-adjusted yields for mezzanine lenders. He acknowledges that RREEF is not unique in spotting this opportunity. “There are many firms trying to execute a strategy and investors are being appropriately cautious,” he says.
BlackRock, for one, is focusing on mezzanine debt recapitalisations of good quality assets. However, the firm is also investing in areas not dependent on job growth, such as the multi-family sector, focusing on metropolitan areas and urban infill projects where job growth is anticipated. Chandler acknowledges, however, that “a lot of other investors see that, too”.
Unlike BlackRock, RREEF is underweight multi-family. “The love affair with the apartment market over the last few years has been justified,” says Roberts. “But you should not overlook the affordability of single-family housing today, which competes with the apartment market.” Historically, the cost of owning has been around $300-500 more per month than renting. But, for the first time in decades, that is inverted and housing has never been more affordable. At the same time, the renter segment of the population, which was inflated from 2005-10, is set to return to its usual average levels by 2015, which could lead to lower growth in tenant demand.
While underweight on apartments, RREEF is more sanguine about office and industrial, taking a pro-cyclical view: the US is past the peak, and vacancy rates have declined in these sectors. As corporations grow, they will hire and tenant demand will increase; real estate values will grow in concert. While in the multi-family sector, investors can benefit by the prospect of rents rolling up, office and industrial will experience three sources of net income growth – declining vacancies, increasing rents and higher passing rents as leases turn over.
Although there are good indicators, there are also major potential pitfalls for investors. “This is not the first decade of the century, when a rising tide lifted all boats,” Chandler says. “Now we have to be very particular about an asset class, the market, the sub-market, even what asset. The difference in performance between the winners and the losers will be much greater.”
Roberts agrees: “It is a bottom-up stockpicker’s market. We have not seen the rising tide that lifts all markets, so it is essential to be very prudent in your underwriting.”
Roberts noted that the market, overall, is very bifurcated; there are some areas with marked recovery and others that are lagging significantly. For example, recent studies have shown that employment is growing very selectively. There are roughly three job vacancies for every one jobseeker in healthcare, telecoms, and computing. This will benefit real estate markets in Boston, Massachusetts; Austin, Texas; and northern California, which have a high concentration of employment in these sectors.
On the other hand, Atlanta has a high concentration of employment in the construction industry, and with the office and residential markets overbuilt, unemployment remains high and there is less tenant demand for real estate.
Nonetheless, foreign investors are eyeing possibilities in the US. “We have seen a steady and possibly increasing flow in foreign capital into the US. Having part of the portfolio in US dollars provides stability,” says Chandler. “In fixed income, there is a flight to quality, and in real estate there is a flight to the US.”
The prospect of higher taxes could prove to be a disincentive to foreign investors, says Chandler. “Global capital is very fickle. If we raise taxes, it will go somewhere else, or it will go into another asset class.”