It’s fair to say that the last 2 quarters have been nothing like sailing on the serenity of a Swiss lake. Volatility has remained high, rather uniquely, in both the bond and equity markets at the same time making asset selection and buy/sell decisions more complex.
I’m currently following Damian Browne’s incredible journey to row solo from New York to Galway in his attempt to break a world record. His daily updates from the solitude of the raw and unforgiving Atlantic are inspiring to say the least as he zig-zags through wild currents and storms – often requiring him to delay or change course. While very different from the tribulations of markets, if I can draw one parallel, it is that the journey forward is never a straight line and it takes patience, strategy and a clear mind to make it to a desired destination. I would recommend following Damian’s journey online to anyone who has even a remote interest in the resilience of humans.
Rates and Inflation
As we enter Q4 2022, it remains challenging to determine the trajectory of financial markets, bond yields, credit spreads and inflation adjusted returns – in just about all asset classes. While the Federal Reserve’s actions in the US are potentially tracking towards a downturn there, the Eurozone is likely to also experience an economic downturn from the combined inflation-driven ECB rate increases and the energy cost/security challenges which will be faced this winter. That said, the depth, and importantly, the length of such a downturn is unknown. The fundamentals of it will differ from that which were experienced 14 years ago, and we must remember that there is an underlying strength of household savings, corporate balance sheets and a general lack of corporate overleverage coming into this part of the cycle which places the consumer economy in a stronger position. Furthermore, governments are providing more support to both businesses and households as we saw during the pandemic.
Backward looking- inflation data, job creation and other indicators – as of the end of August continued to drive central banks’ aggressive interest rate increases. However, within those headline numbers other data points do show their actions are starting to have the desired effect of dampening demand driven inflation, to some degree. Some examples of which:
- Existing US Home Sales for June declined by 5.4% compared to decline forecasts of 0.3% and a prior month decline of 3.4%.
- US mortgage applications in June were at their lowest level in 22 years.
- In Germany, the IFO business survey in June came in weaker than expected with businesses downbeat on economic growth in the coming months.
- In the US, retailer Walmart issued a profit warning saying that consumers were spending more on essentials instead of on higher-margin items.
- Trend in weaker US housing data continued in August with New Home Sales declining by 12.6% in July vs forecasts for -2.5%.
- In Europe, Composite PMI readings for the EZ in August, France and Germany all came in below 50, but were however in-line with forecasts.
- Also helping the inflation narrative is the decline in crude oil with Brent and WTI. In the commodity sector, industrial commodities were weaker also.
- Lumber prices have dropped to pre-pandemic levels, with futures at $410.80 per thousand board feet as of the end of September, a 70% drop from their peak in March.
In the current strange economic circumstances, such negative news is what is needed to avoid much higher interest rates and in-turn more economic pain. Currently there is very little consensus from market experts as to the exact path for rates, further exemplified by different commentary from policy makers in the Fed: Hawkish comments at the end of September were followed by the Chicago Fed governor stating: “By spring of next year we are going to get to a funds rate that we can sort of sit and watch how things are behaving…And if inflation starts to come down, things will be more restrictive and we would want to adjust downward.” Safe to say, it’s difficult at this moment in time to forecast future rates.
Impact on Bricks and Mortar
So why all the focus on rates when it comes to real estate and how does this all read through into property? That is a complex question in itself. Real estate yields, particularly in the last 3 decades, have carried a risk-premium over sovereign bond yields for many reasons. However, in the current inflationary environment, the spread over index-linked bond yields is likely more prescient, particularly for the commercial property sector which benefits from inflation-linked leases.
One thing that distinguishes real estate from more liquid asset classes is the longer term view that must be taken on returns and similarly the projections which inform those decisions. Furthermore, property transactions carry higher in and out costs making prices stickier for both buyers and sellers. Crystal balls aside, however difficult it may be to take a view on how the long-term rate environment affects valuations, it remains essential to do so. Similarly, affordability of underlying lease rates/rents in inflation modelling can be fraught with compounding risk and must be sense-checked.
With this complexity and stickiness, it is not surprising then to note that real estate valuation adjustments tend to lag more liquid market movements by a number of months. The current volatility in equity and bond markets thus poses the difficult question as to where inflation and interest rates will be in 1, 2 and 5 years – the rate of change of these in either direction will be a key factor in the lagged adjustment of real estate values.
We must also remember that credit is the lifeblood of real estate. When the swap rates are changing at such a fast rate, debt is more difficult to secure and reduces the equity yield of the investment as financing costs exceed the property yield. This further dampens real estate deal activity as bid / offer spreads widen. This does however bring in price exploration and cash buyers tend to rise to the top.
On costs, inflation adds a further hurdle to delivery of new stock, even in a supply-challenged market. Globally commodity price inflation for many construction materials has tempered, with some, such as timber having retreated. Also, we are hearing anecdotally from clients that subcontractor availability and openness to tender work has increased from mid-summer which may drive price competitiveness. Is the tide on costs perhaps easing?
Opportunities will continue to arise in the commercial property sector in Ireland, particularly for those investors who take a longer term view on valuation and the strong fundamentals of the market – this is particularly the case for assets in strong locations with high ESG credentials, a well-managed cost base and high quality lease characteristics.
Looking out over the bay
If a scenario emerges where inflation persists long-term, a higher-rate environment would need to be adjusted to, but in parallel inflation-linked spreads and returns in real estate would have to predicate analysis even more. However, with all of this in context and some of the central bank actions appearing to already be making some impact, if inflation indicators begin to turn in the US, the forecast on base rates, and sovereign bonds spreads, is likely to improve which should help to reduce volatility and provide a more stable basis for property valuation. This should also lead to increased risk-on appetite in the real estate sector globally, and in Ireland.
The devaluation of the Euro relative to the US dollar is also a factor that will attract capital to Ireland, particularly from jurisdictions where an institutional investor’s domestic currency is USD pegged. While the British pound is similarly weakened, the recent political turmoil and post-Brexit impact on the economy there, may actually help to direct attention of capital to the FDI success story that is Ireland.
In Ireland, the underlying strength of the economy, continued investment into Ireland, sectoral supply demand imbalances and lower household debt, should offset a number of potential headwinds. For example, the residential build-to-sell housing sector is likely to show resilience for a number of reasons:
- there are now more incentives and government supports for home purchasers.
- the conservative CBI macro prudential 3.5x LTI lending rules make mortgage affordability more resilient to rate rises.
- the State is an increasingly active purchaser of homes for social and affordable housing.
- there are further constraints and challenges on the supply side of the equation.
While sustainability has often in the past been a secondary criterion when economic challenges present themselves, delivering highly ‘green’ buildings is likely to be the sector’s biggest opportunity going forward. Rental and yield premiums are already evident in global markets including Dublin for the most sustainable buildings where secondary and tertiary CBD stock is being left behind in places like New York for example. With the EU Taxonomy to be in full force by 2030, full demolish and redevelopment plays may have to be evaluated on a viability basis against extend and refurbishment approaches.
In the debt space, increasingly more debt providers are quoting floating rate terms to counter the rising base rate environment. This means borrowers need to determine whether it is better to fix now or ride out the base rate curve and much will depend on a borrower’s own view on the future. More conservative institutions are further requiring borrowers to fix the rate for a certain term and pay what are currently high swap rates. An alternative to floating rate debt is a fixed coupon loan note, which is provided from private capital sources which are de-coupled from interbank rate movements. In a rising and volatile rate environment, such loan notes can be attractive to borrowers to provide more certainty around effective term borrowing costs.
While we all continue to try to make sense of market forces and seek to forecast scenarios for the future, the strong fundamentals of investment in Ireland remain – it is identifying the right opportunities at any given time and optimising the capital sources to maximise returns in the long term. At Cantor Fitzgerald, we and our global colleagues in the real estate capital markets team will be happy to discuss your financing or capital requirements as we navigate the coming few months and seek opportunities out on the horizon.