Real Outlook Worsens For Office, Retail Properties
MyEListings' markets and economics editor and creates content about global macro events and their impact on US commercial real estate.
Real interest rates, defined as nominal rates minus ‘the’ inflation rate (in parens because aggregating inflation accurately is largely impossible), are ripping higher, sending debt and currency markets into turmoil. This is because other governments that use the US dollar to trade between themselves must adapt their monetary and fiscal policies to what the US Federal Reserve does, and many simply can’t. This figuratively tears at the fabric of world markets, as they are still quite interdependent, and translates into lower valuations, all else equal, for any asset valued as a function of its periodic cash flows, from bonds to real estate to farms to businesses. And it suggests further weakness ahead for retail and office properties, specifically.
Background
Earlier this week, the Bank Of England was forced to capitulate and reignite quantitative easing, a scheme wherein central banks essentially print the money to buy assets out of thin air, thus providing short-term relief to markets, but at the cost of future payback with interest. The US Federal Reserve, being the defacto issuer of the global reserve currency, has been hiking rates since March of this year, at a historically fast pace, having raised the federal funds rate target by 75 basis points (0.75%) on three occasions this year in an effort to curtail galloping inflation. Other countries, end users of dollars themselves, must accommodate these hikes into their own monetary policies, or risk financial catastrophe; ah, there’s the rub.
They risk financial catastrophe either now, or later. That’s their predicament. Of course, they choose later. Had the Bank of England not intervened, British pensions would have had 90% of their collateral wiped out given a few more small rate upticks - they had to act. The problem with this is in doing so, they simply kicked the can down the road an undetermined distance, and in this environment, that indeterminacy is likely very short-lived. This could, in other words, threaten more than 90% of pensions, in short order.
UK Is The Tip Of The Iceberg
But wait, there’s more…Russia just had its Nordstream 1 and 2 pipelines purposely sabotaged, all but admitted it’s on its last leg as a political entity, and China had to intervene today in its currency market to keep the yuan from depreciating like a dandelion in a hurricane, while actual real deal protests raged in Shenzhen, the country’s showcase economic and export engine. And things are just getting warmed up. We are still very much in the early innings of this game, which leads us to our next point: this is thematic.
The US Is Still Relatively Better-Off
We have discussed the theme of the US being relatively better off going forward as the rest of the world circles the drain. Being the issuer of the world reserve currency coupled with insurmountable geographic, and therefore security and economic advantages brings with it certain advantages. Among these are the abilities to keep conflict from its shores and to maintain the initiative in the world, forcing other countries to respond to it, not vice versa.
The Marginal Unit Sets The Price
Having said that, as economists are fond of saying, the marginal unit sets the price. This means the next unit sold sets the price for the following sales, because in a world economy, even with regional pockets of dynamism, any asset sold is an asset that can’t be sold elsewhere or to someone else, and therefore affects marginal prices in those markets. For example, in the US, natural gas is essentially a waste product. It is a natural product of shale condensate extraction, and since so many shale wells have been completed in the last 15 years, only a fraction of them have been hooked up to pipelines to deliver the waste gas to markets. This means every cubic foot flared off at a wellhead is a cubic foot not sold on any market. It also means any cubic foot sold here is a cubic foot that cannot go elsewhere, like Germany, and this begets higher prices for gas ‘over there.’
What This Suggests For US Commercial Real Estate
Categories within the scope of CRE most negatively affected by the ongoing turmoil in money and debt markets are those that have already been beaten down, namely office and retail. Markets don’t move in smooth, continuous curves, but more like stepping along a saw blade. And we are likely due for another step down in these asset classes, particularly.
The reasons for this have more to do with money and debt markets than with the CRE market, per se; nevertheless, they weigh a lot, and demand consideration. There are many ways a deal can turn south, and if one were inclined to try to count them, then hiking rates 250 basis points inside of 6 months after printing up 40% fresh new dollar units over the past 2 years would be a good way of seeing them.
Things overheard…
There are already many anecdotal reports of deals having to be retraded after completing earlier this year and even late last year. Smaller deals, mostly, but many do not pencil to where owners underwrote to low cap rates, and in a rising rate environment, cap rates are vulnerable and must come up to attract the risk-taking required. Banks and bridge lenders are largely tapped out, opening the doors to smaller, less-well-capitalized lenders, and increased risk in the system. This represents a major opportunity for well-capitalized bridge and construction lenders.
Additional opportunities exist for investors and developers with good working relationships with zoning and land use policy personnel, as many office and retail properties may have to be replaced if not repurposed. Organizations able to construct a viable strategy that works at scale will have a major advantage over those without these assets once an upswing inevitably begins anew. In addition, investors with access to global financial intermediaries have the advantage of being able to borrow in weaker currencies such as the Swiss Franc, Japanese Yen or even the Turkish Lira to purchase US assets, and this ‘carry trade,’ as it is known, can add a financial margin of safety to a project, as returns earned in the stronger currency can be converted to the weaker currency and repaid in these cheaper francs, yen or lira. This requires additional vigilance but can represent a somewhat esoteric way of securing greater breathing room and return on an investment.
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