Year-end reflections

December 23, 2013 admin

As 2013 draws to a close, I’ve been thinking a lot about the discussions we’ve been having with investors around the globe. As readers of this blog post might remember, we hold several Editorial Advisory Board meetings in different locations around the globe each year.

This year, we’ve met with investors in Laguna Beach in Southern California, in Bangkok, in Rome, and in Half Moon Bay just south of San Francisco — investors from more than 120 different investment institutions, who collectively control well over $4.5 trillion in total assets, including more than half a trillion dollars in real estate and infrastructure assets under management. And, as I think back on these discussions, several themes seem to emerge.


The first of these is capital, or more specifically, too much of it. Central banks around the globe, but particularly in Europe, the United States and Japan, have been vigorously engaged in a multi-year program of quantitative easing. Quantitative easing is a euphemism for government-sponsored bond buying programs. Essentially, the central banks have been printing new money and deploying that newly minted money to buy up mostly government or government-backed bonds in the open market.

In the U.S. alone, the Federal Reserve’s activities have driven money supply (M2) from roughly $7.6 trillion in 2008 to more than $10.8 trillion by 2013. That’s a 40 percent run-up in the supply of money in just five years.

The intent of these bond-buying sprees by central bankers was to support flagging bond markets that, in the wake of the Lehman Bros. collapse, appeared to be on the verge of collapse.

The intent also was to keep demand for bonds high relative to supply and, thereby, to help keep the lid on interest rates that otherwise might have risen rapidly due to the market’s perception of the riskier post-GFC environment.

Central bankers also hoped that all that money they were printing would eventually find its way into the consumer markets, eventually stimulating growth in the form of investments in new plants, equipment and the jobs needed to deploy those capital investments.

They did succeed, at least on the first two counts. But instead of stimulating investment in physical plant, equipment and jobs, most of that fresh new capital found its way first onto the balance sheets of financial institutions (the largest segment of the bond-buying marketplace) and, eventually, into the equities and alternative asset markets, including real estate.

Since the natural human reaction to financial downturns is to retreat toward quality, not surprisingly, most of the money moving into real estate has been targeting the ostensibly safer core property types and markets. This has held cap rates down to historically low rates for a surprisingly long time.

Meanwhile, as the economies of Asia have continued to grow, capital has been forming and concentrating in the hands of large Asian financial institutions, such as the fast growing pension funds of Korea and the huge life companies of China, which have been given the license to begin to deploy capital more aggressively globally.

In addition, the massive, fast growing sovereign wealth funds continue to increase their investment activities around the globe, joined by a huge influx of more entrepreneurial capital from a growing cadre of ultra-high-net-worth investors, including many of China’s newly minted billionaires.

All of this money has been competing with traditional Western pension fund and financial institution capital. But because these newbies have no or much lower current yield requirements, the traditional investors are finding it increasingly difficult to get their mandates prudently invested.

Frustrations are growing, and frustration eventually leads to different strategies. Some of these more traditional investors are ramping up to execute more “build to core” types of strategies. Others are casting their nets wider, either by beginning to invest in core properties in markets that a year ago would not have been considered prime targets (suburban and second-tier markets, for example.)

Some are seeking to meet their investment objectives by investing in more niche-type products that they believe can deliver core-type investment characteristics, such as senior housing, student housing, self-storage, medical office and related traditionally noncore type investment strategies. Real estate debt–related strategies such as whole loan, mezzanine and securitized investing are being pursued by some traditional core investors because they view these alternatives as reasonably suitable core substitutes.

Still other investors have determined that, at this pricing, it might make better sense to sell off a good percentage of their existing domestic core property holdings and redeploy the net proceeds in core investments in alternative, nontraditional assets, build-to-core (and hold) strategies, and/or by making core investments in offshore markets.


Investors around the globe, however, also are increasingly and nervously eyeing the other guy’s hands. Because economic developments in one region of the world can now have such huge impacts on developments in an investor’s own domestic markets, no one is investing without white knuckles these days. Consequently, given the underlying vulnerabilities baked into the economies of Europe and the Americas in the face of changing political and economic forces, no one in property investment land seems to be having very much fun — not even the most active of investors.


Quantitative easing policies have proven to be a tiger that is easy to mount, but from which it is has proven much harder to dismount. Just the whisper from a former U.S. Fed chair that the Fed Open Market Committee might be thinking about possibly engaging in a gradual tapering of its bond buying program sent the bond markets around the globe into a state of disarray. Imagine the potential impact were the Fed and other central bankers actually to begin to implement a bona fide tapering program.

Tapering, of course, is only the beginning of the unwinding process that eventually needs to take place. Don’t forget, after tapering comes to a close and the government eventually stops actively buying in the bond market, the next step will be to gradually de-monetize the system by selling back into the market those trillions and trillions of dollars of bonds holdings they’ve been steadily accumulating.

Don’t expect to see any of that happening any time soon, however. If the market can’t sustain itself in the face of even a mention of a possible pending tapering, it still isn’t strong enough to sustain a series of actual “for real” tapering measures.

What this ultimately means is that the apparent relative strength of the bond market today is nothing more than just an illusion. The market still isn’t strong enough to stand on its own two feet.

At least, that’s what the bond markets today seem to be telling us.


With all that new money circulating, many investors believe it’s only a matter of time before we start to see real inflation begin to rear its ugly head in the markets. If and when we do see such inflation, most investors seem to believe it will be moderate and controllable and, therefore, probably good for the real estate markets.

Part of the reason for this relatively positive outlook is the fact that, despite a gradual economic recovery, there hasn’t been much new development in the past several years, at least not since the global financial crisis first began to unfold.

If economic growth engines begin to rev up, it should continue to be a landlord-friendly leasing market for some time. That should enable owners to pass along a good percentage of any run-up in operating costs to their tenants, and, therefore, most investors believe real estate should continue to provide a reasonably good inflation hedge, at least for a while.

Interest rates

Most investors believe interest rates eventually have to rise. But most also believe central bankers will continue to hold the lid on rates for as long as they can, and that any rate hikes that do emerge are more likely to be relatively moderate and manageable than horribly radical and disruptive.

Capitalization rates

Most investors also seem to believe that capitalization rates will rise along with interest rates. Most also seem to believe that cap rates, when they do start to move, will only move up grudgingly, and not as dramatically and not as quickly as interest rates are likely to move. (And, remember, they don’t expect rates to rise by much.)

Many investors also believe that any eventual upward movement in cap rates will most likely be offset by corresponding rises in rental rates and, ultimately, increases in net operating incomes. Consequently, few investors are very worried.

There is some evidence to support this rosy view. Data and analysis developed by CBRE suggest that when interest rates rise, cap rate spreads tend to widen, and, therefore, cap rate rises do tend to lag the rises in interest rates.

But not everyone is so optimistic. Some point to the long-term historical record for NOI growth and argue that if interest rates rise higher than 200 basis points or faster than most expect, there is no precedent for the kind of NOI growth rates you would need to see — and sustain — in order to keep values from dropping.

Meanwhile, property underwriting continues to be a game of jiggling your numbers and assumptions. How much do you have to push your rental rate growth assumptions and your net operating income figures in order to offset for each 100 basis point rise in assumed inflation, interest rates and capitalization rates? So underwriting, too, has become no fun for most investors.

The ultimate question

The ultimate question comes down to: are these investors right? Will inflation and interest rates rise? And, if so, will they only rise moderately? And how soon? And, if they rise, no matter how high or how fast, how much and how fast will cap rates move in sequence?

Black swans and the bottom line

Many of you may be familiar with Nassim Nicolas Taleb’s classic work, The Black Swan. Taleb’s thesis is that the market often ignores or fails to plan for surprising events.

In the titular example, for centuries, almost everyone believed all swans were white and there was no such thing as a black swan — until, that is, one was finally spotted. Now, everyone knows black swans are quite common if you only know where in the world to look for them.

Before the global financial crisis, everyone knew that the deepest the U.S. housing markets had ever dropped was 14 percent in a year. This was true, of course, up to and until the time directly following the crash of Lehman, when the U.S. housing market dropped more than 45 percent in one year.

The March 2011 Japanese nuclear power plant accident occurred precisely because the plant had been designed to withstand the largest earthquake and flooding conditions to which the nation had ever been subjected — instead of the conditions that it actually experienced when the most recent earthquake and resulting tsunami actually hit.

Part of the reason we miscalculate these kinds of “surprises,” Taleb points out, is because we assume the worst that is likely to happen has already happened at least once. We often fail to consider the worst that actually could happen may simply not have happened yet. We assume, because we’ve never seen a black swan, no black swans actually exist.

Right now, most investors seem to be thinking the worst that could happen to interest rates, and the worst that could happen with inflation, would be something in the order of magnitude of a 200 basis point rise. They also are assuming that when these rates eventually do rise, any corresponding cap rate increases will lag.

Not only are these assumptions ignoring the worst that could happen, they aren’t even considering the worst that actually has happened in the past. Right now, the U.S. 10-year Treasury rate stands at 2.57 percent. Just 12 months ago, it stood at 1.68 percent. That means interest rates have risen already by 52 percent in less than one year’s time.

Unfortunately, because rates have been so relatively low for so long, most people aren’t even taking into consideration how high they could go, not to mention considering the forces that most likely could drive them there.

When, for example, was the last time we saw interest rates at 6 percent? The answer is 1997, or about 16 years ago. When was the last time they were at 8 percent? 1991, or 22 years ago. At 9 percent? 1989, or 24 years ago. At 10 percent? 1980, or 33 years ago. For many of you younger real estate professionals today, that’s equivalent to a lifetime ago. And because many of you haven’t seen these kinds of rates for a long, long time, too many of you are assuming we may never see them again, at least, not in your own remaining business careers.

What you may be missing here is what actually happens to relative asset class demand when interest rates rise.

Right now, there’s a lot of money that has been squeezed out of the bond market by the central bankers’ buying activities and by the prolonged and relatively low interest rate environment. Much of this money has found its way into the equities markets and alternative assets, such as real estate, which has been driving all the property asset inflation we’ve been seeing of late.

People tend to forget that this is not a “normal” environment.

When I first came into the business, most pension funds had 35 percent to 50 percent — and some even more — of their portfolios invested in the bond market. Today, at least for pension funds in most Western nations, bond market exposure is lower than 25 percent to 30 percent of total assets, and even lower for some.

Why the dramatic reshuffling? Back when allocations were higher, interest rates were higher — in the 6 percent or higher range. And that, on a relative basis, made the bond market a great deal more attractive to these kinds of investors.

If interest rates were to rise 300 basis points or 400 basis points, for example, the bond market would start looking a whole lot more attractive to pension and similar long-term investors. If you can get closer to your actuarial investment return underwriting assumption at far less risk, why wouldn’t you reallocate and redeploy more of your portfolio into bonds? (Same goes for individual investors, who typically — particularly as they approach or become engaged in their retirement years, as most of us boomers are — prefer low-risk, relatively high yielding investments such as higher-yielding, strongly rated debt securities.)

Consequently, in the face of that kind of dramatic uptick in rates, a lot of money is likely to find its way out of the riskier equities and alternative asset markets, and back into the bond market. Will this happen? Is it even likely to happen? No, probably not. The point is, however, it could happen, and very few have factored that possibility — even assuming a low probability of occurrence — into their investment strategies.

The bottom line here, as I like to note at the end of most of my editorials, is: “It’s important to be careful. It’s important to be very, very careful. After all, it’s a whacky world out there.”

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GeoffFinalv5forwebGeoffrey Dohrmann is president and CEO of Institutional Real Estate, Inc.

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