These Three Impending Geopolitical Events Will Drive US Cap Rates
MyEListings' markets and economics editor and creates content about global macro events and their impact on US commercial real estate.
The spread between US treasuries and aggregate capitalization rates on US commercial properties is driven by investor risk perception. This is heavily influenced by happenings around the world that impact relations between various countries, their relative economic output, and global interest rates.
How The Yield Curve Drives Cap Rates
Investors, rightly or wrongly, consider US treasury securities to be `risk-free` investments. This provides a visible and dynamic baseline against which they can compare other cash flow streams, to generate a spread. This spread can be valuable for ascertaining the risk premium associated with an investment, versus a known risk-free quantity. Of course, being `risk-free` in terms of return simply refers to the fact that the US government can print the money to fund its obligations; it makes no claim to this money`s value, which is subjective, and implies risks to value do, in fact, exist in government securities.
Cap rates are a mechanism investors use to convert expected cash flows from real estate into net present value of the investment. They are inversely correlated with valuations, so a property with a 2.5 cap will be worth more price-wise than one with a 4 cap. The spread, or difference between cap rates and risk-free rates, specifically the benchmark 10-year bond, represents a dynamic estimate of the perceived value of the risk one must take to own an illiquid piece of property as opposed to a US treasury bond. Therefore, we can say bond yields drive cap rates to an appreciable degree.
How Relative Inabilities Shape Macroeconomic Outcomes
A country`s inabilities define the edges of its limitations. This is because inabilities tend to be hard limits whereas abilities tend to be expressed in terms of degree. A country with no oil reserves, for example, must trade to meet its energy needs, and cannot field an army, for example, with its own resources. Likewise, a country without a sufficient consumption base is forced to export if it is to continue growing, and this assumes willing buyers in other markets.
Other Countries` Outcomes Affect US Investment Expectations
The United States has become not only the largest economy overall in terms of GDP, but more specifically in terms of consumption. This fact gives the US leverage in its interactions with other countries, not just in political terms, but in economic terms as well. Nearly all export nations would prefer to sell to the US market, and the most forward-looking of US trade partners now co-locate their manufacturing and logistics facilities alongside their preferred customers. This trend is likely to accelerate in the future, which could help support demand for industrial, logistics, data center and even office and multifamily properties.
US investors form their expectations from the data and machinations they consume in media and experience, which are in turn products of a global economy today.. Typically, these expectations are gently-moving, without short-term surprises; but in today`s global economy, there is quite an underappreciated cause for movement in this regard. To be specific, there are three very large and important geopolitical players quickly hurtling toward critical states, and these will affect the investment environment worldwide, including the US. These are Russia, China and the European Union.
Russia
Since the collapse of the Soviet Union in 1990, the Russian Federation has failed in all respects to diversify its economy, to properly educate its citizens or to maintain its military to a high standard. Russia has the third-fastest-aging population in the world, thanks largely to governmental mismanagement. Educated Russians have largely left the country at this point, and the most educated of them are in their fifties or older; moreover, those with the knowledge base, experience and education to execute high-level governmental functions number only perhaps 200 individuals.
Against this backdrop, Russia has been invaded roughly 50 times in recent history, making the Russian security picture one of perceived lack. Geography dictates to a large degree any nation`s security policy, and Russia`s reflects this insecurity due to its extremely long land borders and proximity to potential invaders. Its solution, historically, to paraphrase Katherine The Great, has been to expand. In the Russian mind, this is imperative. Long, flat borders are by definition insecure, as they are easy to cross and keep going.
Russia`s greatest security position was attained as the Soviet Union, when it controlled the security policies and to a great degree the internal politics of buffer states on its periphery, and this condition stands as its goal to re-attain. It is for this reason that the country has systematically co-opted the internal politics of former buffer states, such as Georgia, Azerbaijan and Kazakhstan. But it failed to achieve this in Ukraine, due to US sabotage of the effort. This led to one of the most ill-advised, poorly equipped and executed invasion attempts in history.
The US, for its part, can do this ad infinitum, and can act by proxy without involving its own troops to ensure Russia stalls and fails in Ukraine. The realistic consequence for failure would likely be similar invasions of NATO countries comprising its former buffers.The sanctions so far imposed are only now beginning to bite, and Russia`s internal cohesion to fray. Combine this with a population that will halve in the next 20 years, and we have a situation. Historically, Russia falls apart and reconstitutes itself fairly quickly. Next time around, expect a younger generation of foreign-educated Russians to take up the mantle of government, and create something relatively new. The implosion and irrelevance, however, must occur between now and then.
The EU
The European Union is predominantly a Franco-Germanic experiment to attempt to solve the problem of strategic-scale, massively destructive wars on the continent. World wars one and two were so costly to the continent, the two largest economies first put together a common economic zone, which worked reasonably well, before its creators pressed their bets and created a common currency.
The problem with creating monetary unity without actual political unity is obvious upon examination: if serious political differences exist, then fiscal and monetary policy prescriptions must be different between them. What is good for Germany is not good for Spain, and Spain in fact requires entirely different strategies to succeed. Yet they`re part of the same political union, and each issues its own sovereign debt. This is a time bomb awaiting a trigger.
Russia is currently pounding economic and political wedges into the heart of the EU, with natural gas, wheat and fertilizer exports, primarily. And, as also common, they`ve miscalculated. The EU would likely disintegrate on its own due to internal differences in time, anyway, and forcing the issue forward in time won`t necessarily end up as contemplated. A disintegrating EU most likely resembles a preschool class where the teacher tells the class what to do, and few, if any listen. Instead, constituent nations will likely form alternative alliances, and continue with the EU existing in name only.
China
China will offer perhaps the most spectacular economic, and likely political implosion the world has yet seen. This idea tends to contradict conventional wisdom about China, but said wisdom is largely based on Chinese propaganda. In reality, China has the second-fastest-aging population, and has systematically overcounted its population, lied about economic data and misrepresented both its intentions and actions in joining the world economic community and its institutions such as the UN, World Trade Organization and Bank of International Settlements.
Historically, China tends to fracture politically along geographic lines. Its coast gets wealthy, its interior remains poor, and then goes on long marches to even the score. Eventually it congeals into regional alliances, and is only `united` by force, under a strong enough emperor. This is because China`s geography does not facilitate cohesion. Only three navigable rivers exist in the country, and they do not connect. This means people along these river systems are independent and do not necessarily share a fate with people along others. Each river system constitutes its own de-facto economic system. Shanghai, Guangzhou, Hong Kong, Macau, and Hainan have no reason to obey the dictates of Beijing, but at gunpoint.
Lastly, we have a Chinese hyper-financial model that treats capital like a political, rather than an economic good. One result of this is the Chinese Communist Party writes loans like a clown throwing candy from a parade float, with little regard for the fact these represent the economic ability of its people to exchange value. As a result, off-book debt levels positively dwarf reported ones, and the reported ones are, in a word, massive.
Synthesis: What Does This Suggest?
One inescapable conclusion from this sad state of near-criticality is that sovereign debts will need to be worked out. The only economy and government in a position to orchestrate any such process is the US`. The US dollar is already the world`s reserve currency, meaning it is in use not only by US trade partners, but by those partners with each other and their trade partners. This means US monetary policy affects the world. By hiking rates on the world reserve currency when end users cannot raise their rates in lockstep, or require an opposite policy for their own current needs, serious frictions can develop. The US could be forced to operate its monetary policy for the good of its trading partners rather than itself, past a point. As goes monetary policy, so goes the yield curve. As goes the yield curve, so go cap rates. And as go cap rates, so go the net present value of commercial properties.
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