“A lie which is a half a truth is ever the blackest of lies.”—Alfred, Lord Tennyson
There has rarely been as much confusion in the financial and real estate markets as there is today. In the stock market, Brexit occurred and the market rallied after a one-day crash. The markets were supposed to similarly crash when Donald Trump was elected, and they rallied instead. Interest rates were universally predicted to stay low for years to come, but instead they spiked at the end of 2016. Manhattan residential real estate was considered to be absolutely bulletproof but instead has shown real softness for the high-end units. It’s as if we are in the Costanza Opposite Effect, made famous by George on Seinfeld, where he does the opposite of every instinct and it all works out! So how do we make sense of the markets, specifically real estate, going forward?
Let’s start with money flow, which usually trumps all other factors. The Middle East and Asia were buying U.S. real estate as fast as they could deploy it for the last few years and through the summer of 2016. In many cases, this inflow was due to currency considerations, safe haven buying and other nonmonetary reasons like the Chinese trying to get money out of the country. A tax exemption passed in December 2015 also made it easier for foreign stock funds and real estate investment trusts to buy U.S. real estate, exacerbating this inflow of foreign capital. Beyond their commercial purchases, foreigners bought $102.6 billion of residential real estate between April 2015 and March 2016 (Source: National Assn. of Realtors). The Chinese dominated these purchases with $27.3 billion, and as for geography, Florida, California and Texas combined for 47 percent of the acquisitions.
While some of that foreign flow still exists, it clearly has slowed considerably. The rising dollar has made foreigners skittish to continue making large purchases until the dollar retreats. The Chinese in particular are feeling deflationary forces for the first time in a decade. Domestic bubbles in the Chinese economy have started the deflation as economic prospects sour. The capital outflow has caused China to intervene in its currency, but unlike the U.S., their printing presses are limited. China could easily end up with the double whammy of a weaker Yuan and no economic growth. The net effect to the global economy has far reaching implications beyond just fewer Chinese buying $10 million apartments and $50 million office buildings, but for purposes of this article, just know that the immediate effect is less Chinese real estate purchases. Meanwhile, one-third of foreigners surveyed in fourth-quarter 2016 at an AFIRE conference said that they felt more pessimistic about U.S. property markets, up from 8 percent in late-2015 (Source: Wisconsin School of Business). Meanwhile in Europe, one wonders if the EU banking system will continue to deteriorate, and if it does, will it be a positive as Europeans deploy their capital elsewhere (like the U.S.) or, more likely, a net negative as Europeans won’t have excess funds to invest.
So if foreigners are going to decrease their purchases, there is room for domestic institutions to fill that demand bucket. Indications are that domestic demand has similarly slowed with many funds becoming net sellers in an effort to take advantage of higher prices. The combination of falling demand and substantial new construction coming online could very well mean that 2017 is a down year. The stock market continuing its meteoric rise has ironically become a viable alternative to real estate for insurance companies, hedge funds and pension funds alike. Institutions vividly recall the illiquidity that comes with real estate during the last recession of 2008 and like the liquidity of the stock market.
Rising interest rates have also impaired leveraged returns on real estate somewhat. While interest rates have bounced off their recent high yield of 2.6 percent on the 10-year Treasury established in mid-December 2016, they are still considerably below their lowest recent yield of 1.7 percent on the 10-year Treasury which was around Labor Day last year. So long as we don’t pierce 3 percent on the upside, it is likely safe to say that it won’t have a corresponding impact on cap rates. In fact, the spike in interest rates that has since receded should act as a warning shot across the bow. Owners would be wise to heed this warning and refinance every property with 10-year fixed rate, nonrecourse, maximum leverage financing as lenders are very aggressive currently. (Avison Young recently arranged the financing for a $55 million loan on office/warehouse buildings in Florida at a full 75 percent LTV at 230 basis points over Treasuries [4.65 percent currently].) As for the equity markets, one can only hope that the opposite effect continues as the fundamentals point to a flat to downward 2017.
Dan E. Gorczycki is a senior director for Avison Young New York where he specializes in mortgage brokerage, structured finance and joint venture equity raises.