Market Volatility and the Effect on U.S. Commercial Real Estate

Market Insights
February 12, 2016
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Chief Economist

There’s been no shortage of volatility to start 2016. Amid dramatic sell-offs in global equity indices, commodities and emerging market currencies, financial markets have opened with a collective thud. Causes offered for the instability include: fears of oil oversupply, worries that monetary policy will be ineffective in boosting inflation and concerns over a China-led slowdown are all frequently offered as rationale. However, how does recent market volatility affect commercial real estate?

A confluence of events may lead to another year where U.S. commercial real estate holds up well relative to other markets in disarray.

1) Further U.S. dollar appreciation = added source of return for international investors

The U.S. is one of the only countries that has begun monetary policy normalization, with the first increase in the Fed Funds rate (the interbank overnight lending rate for reserves) having occurred in December. 10-year government rates in the U.S. are higher than similar maturity rates in Canada, the U.K., France, Germany, Italy, Spain, Denmark, Sweden, Norway, Switzerland and Japan—to name but a few countries. To the extent that higher government yields in the U.S. support further U.S. dollar strength—particularly relative to currencies at risk of further devaluations, such as the Chinese yuan—the currency impact of an investment in the U.S. can provide an added source of return for overseas investors.

Dollar strength has been associated with an increase in overseas investment in U.S. real estate; alongside a nearly 20% appreciation of the U.S. dollar on an inflation-adjusted basis against its major trading partners since 2009, cross-border investors have gone from being net sellers of commercial real estate to accounting for more than 11 percent of all U.S. real estate activity in 2015, according to RCA Analytics.

Chart 1. Cross-Border Net Acquisitions of U.S. CRE as a % of Total Activity vs. U.S. Dollar Index

Source: U.S. Federal Reserve, Bloomberg, RCA Analytics

*Activity = Total Acquisitions = Total Dispositions

Moreover, with more than one-third of the euro area’s government bonds yielding less than the -0.3% deposit rate, more traditional (and theoretically less-risky) assets may be off the table for investors given negative buy-and-hold total returns.

The caveat? Recent fears of global recession have accelerated, and the market has dramatically scaled back its expectations for steady rate hikes from the Fed. Moreover, low (and negative) interest rates don’t necessarily portend currency weakness; the opposite may also be true. For example, from January 29, 2016 – February 9, 2016, the Japanese yen appreciated by 5.2% against the U.S. dollar, even as yields on short-term (3-month) Japanese government bonds fell further into negative territory relative to U.S. 3-month Treasury bills over this period.

As of 2/9/2016

Source: Bloomberg

*Probabilities reflect the combined probability of all terminal rate options from the rate in place at the time of calculation. For example, today’s probability incorporates the likelihood of moving from today's target of 0.25% – 0.50% to 1) 0.50% – 0.75%, 2) 0.75% – 1%, 3) 1% – 1.25% and 4) 1.25% – 1.50%.

2) In times of trouble, real estate’s illiquidity may be a positive

The very illiquid nature of most real estate investments means that when the sky is falling, real estate is usually at the bottom of the “sell” list. There are few, if any, automated platforms for matching buyers and sellers of commercial real estate, and the process of securing financing limits how quickly transactions can be completed.

U.S. REITs have proven to be significantly more stable relative to diversified equities during market downturns. An analysis of monthly total returns for the FTSE NAREIT US Real Estate Index Series (Equity REITs) and the S&P 500 from January 1972 – December 2015 finds that S&P 500 monthly total returns were negative 38% of the time. However, on those occasions where S&P returns were negative, the Equity REIT index performed worse than the S&P 500 just 31% of the time, implying that on a relative basis, equity REITs outperformed the S&P 500 more than two-thirds of the time during those months when overall equity performance was down. Note that while the S&P 500 returned more than 7,300% cumulatively over the aforementioned 44-year period, the NAREIT Equity REIT index returned twice as much—almost 14,600%.

Chart 2. Total Return Indices: FTSE NAREIT US Real Estate Equity REIT and S&P 500

Source: NAREIT, Standard & Poor's, Economagic and

Even if we exclude the recent appreciation of REITs from 2009 through the present, the above finding still holds: from 1972 – 2008, the FTSE NAREIT Equity REIT index outperformed the S&P 500 during down months for the S&P 500 71% of the time.

3) Tax changes favorable for overseas investors in U.S. real estate…

Commercial real estate in the U.S. may also benefit from legislative changes made at year-end that affect the taxation of real estate upon disposition. Qualified foreign pension funds will now be able to invest in commercial real estate without facing a tax on gains upon sale (known as FIRPTA), while foreign entities will be able to increase their holdings in publicly-traded REITs from 5% to up to 10% before triggering tax upon sale of their real property interests.

4) …and U.S. index investors may need to rebalance and add as well

Additionally, equity index funds (and sector-specific funds, in particular) may find a need to increase their investment in REITs to become better aligned with the composition of the overall index. For the first time since MSCI and Standard & Poor’s developed the Global Industry Classification Standard (GICS) in 1999, a new sector will be created: Real estate is being moved out from under its current industry group under “Financials” after the close on August 31, 2016 and will be classified in a newly-created “Real Estate” sector, with non-mortgage REITs falling into a new sub-category as well.

Does all of this point to continued acceleration in CRE activity and a sustained move upward in sale prices per square foot? Not necessarily, although it’s important to highlight that to date, there’s been little slowing of net income growth on a per square foot basis—a metric that has moved fairly steadily upward as cap rates have declined. Risks include underwriting standards that will tighten from current levels and cap rates that are “priced to perfection.” But even if U.S. commercial real estate were to weaken from current levels, chances are the sector will still outperform most long-only investment alternatives in the coming months.

Chart 3. All Property Net Operating Income per Square Foot vs. Cap Rates

Source: RCA and NCREIF

Institutional NOI = Institutional Effective Rent Revenue minus Operating Expense (ground rent, general administrative fees, management fees, marketing and other operating expenses, payrolls/benefits, professional fees, property insurance, real estate taxes, repairs and maintenance costs and utility expenses.

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Heidi Learner

Ms. Learner analyzes the macroeconomic and legislative environment affecting commercial real estate markets on a national and regional basis and develops real-time measures of supply and demand for commercial space.