24 hours that shook the world: Brexit's implications for U.S. Commercial Real Estate
24 hours that shook the world
- Turmoil and uncertainty lie ahead
- U.S. real estate public quadrants have been orderly so far
- U.S. real estate fundamentals look steady for now
- But risks are hovering and need monitoring
- Deep and Liquid U.S. Real Estate Markets Offer Safe Haven
In a close vote, the United Kingdom (UK) electorate recently voted to exit the European Union (EU) under a long-awaited referendum. As anticipated, David Cameron resigned as Prime Minister (PM) due to his failed attempt to convince constituents to remain in the EU alliance. Mr. Cameron will be staying on until October when a new PM is in place. We believe that Brexit risks outweigh the benefit of UK sovereignty, including the potential negative effects on the UK economy and trade, and perhaps even the future appeal of London as a pre-eminent global financial center. As the dust begins to settle on this seminal event, doubts and questions have started to swirl on how and when the UK will exit potentially laying the stage for continued volatility in the coming months. The impact on different asset classes is yet to be fully understood with significant volatility impacting risk assets since last Thursday’s vote. So far, there appears to be little contagion effect on U.S. commercial real estate where investors remain generally constructive on occupier demand outlook.
U.S. real estate public quadrants have been orderly so far
The initial reaction to Brexit by commercial real estate’s public quadrants were generally quite orderly – while commercial mortgage-backed securities (CMBS) spreads have widened in response to risk aversion, demand for the higher quality tranches (AAA) seem to be holding quite well. Similarly, while UK real estate stocks have been hurt with some sectors taking the brunt of the sell-off, U.S, REITs have also held up relatively well. Part of the reason may be the lack of immediate transmission mechanisms between the public quadrants of U.S. commercial real estate and the recent events affecting the European Union’s economic uncertainty. For example, U.S. REITs only derive approximately 4% of their net operating income from offshore. Part of the reason may also lie in the continued search for yield, especially in light of collapsing global sovereign yields.
U.S. real estate fundamentals look steady for now
While risk assets continue to adjust to the longer-term implications of Brexit, for U.S. commercial real estate the most important point to understand is whether this dislocation will weaken occupier demand and investor appetite for the asset class. As the initial reaction by the public quadrants indicate, there seems to be a fair degree of confidence that U.S. real estate fundamentals will not be materially dislocated for now. And looking over the medium-term, the path of U.S. real estate is likely to be determined by: (a) relative global value, (b) outlook for net operating income (NOI) growth and, (c) availability and pricing of debt capital.
A low interest rate environment and an improving growth outlook has significantly reflated U.S. real estate — in many cases above replacement cost and peak pricing levels achieved before the global financial crisis. When viewed in a global context, U.S. real estate pricing appears to be in line or even relatively attractive when compared with certain global markets (Exhibit 1). While these cap rates1 do not reflect transaction pricing in major markets globally (which are 100-150 basis points2 lower depending on market and property type), the variance between the U.S. and some other major markets suggests a case may be made for the relative value of U.S. real estate. For global equity real estate investors the United States may thus appear to be an attractive investment opportunity from both a safe haven and yield perspective — this is particularly true for gateway and other large primary markets that are viewed as stable and more liquid.
For global investors the relative pricing variance between the United States and other major markets is likely to be enhanced by the generally constructive outlook on rent and NOI growth over the next 18-24 months (Exhibit 2). In general, property markets in the United States have vacancy rates at or below equilibrium with strong demand helping support occupancy and rent growth.
Demand for industrial properties is especially strong with investors realizing they represent an interesting opportunity to play the e-commerce and omni-channel strategy that many retailers are embracing. Demand for apartments has held up surprisingly well despite the strong supply response in many gateway markets reflecting perhaps the paucity of affordable housing as well as stiff credit standards that has kept single family sales in check. Office properties are perhaps the most vulnerable to a shift in corporate confidence especially if the U.S. dollar continues to strengthen and impinge on future hiring plans.
The availability and pricing of debt capital is a third factor that will potentially determine the path of U.S. real estate going forward. The impact of Brexit on capital markets has been to raise uncertainty and volatility. There is not yet enough evidence as to whether it has or will have a material impact on the availability and hence pricing of capital. So far, CMBS markets have been orderly albeit with limited transaction volume and price discovery. However, with spreads in the senior tranches (AAA) relatively stable, it would appear that CMBS investors are taking BREXIT in stride and are focused on yield and growth.
The need for assets with relatively attractive yields (such as commercial real estate) within lenders – be it banks, insurance companies, CMBS originators or high-yield private funds is likely to remain strong as the paucity of similar fixed income instruments is laid bare by the continued downward drop in sovereign yields. In fact, there is growing market consensus that an already cautious Federal Reserve will back away from another interest rate increase for the remainder of 2016; some market participants believe that the odds of a rate cut are increasing (Exhibit 3). An environment where global interest rates stay “lower for longer” will add further pressure on yield investors to seek sources to meet their requirements. With the backdrop of a relatively constructive growth outlook, competitive yields and an accommodative Fed, US real estate is likely to remain an attractive investment option for a wide variety of global investors.
But risks are hovering and need monitoring
The full ramifications of Brexit are yet to be fully understood since it is the first instance wherein a major European member state has exercised its sovereign right to withdraw from the European Union. There is gaining confusion on the timing of the exit and indeed if the UK will actually withdraw from the EU which is going to lead to elevated global economic and capital market volatility. A period of potentially prolonged uncertainty is not helpful to the U.S. economy. The potential negative economic impact from Brexit on the U.S. economy is a risk to the U.S. real estate markets and needs careful monitoring.
The simplest method through which the ongoing crisis in Europe may transmit to the U.S. economy is through a sell-off in global equity markets. If there is sustained fall in U.S. equity markets, consumer confidence would suffer and the long awaited rise in increased consumption spending would falter (although the price of imported goods would fall).
A materially stronger U.S. dollar would be another mechanism via which the economy could potentially weaken. A stronger dollar will impact corporate profits, weaken exports and further delay expansion plans by U.S. corporates whether it is capital expenditure or future hiring. A slowdown in consumer spending when accompanied by weakening corporate profits would be significant headwinds to the U.S. economy at a time when it has struggled to gain meaningful growth traction seven years into the recovery. And ultimately, a slowdown in the economy is at this stage, the most material risk to U.S. real estate because it could impact rent growth which is likely to be the most significant driver of future investment performance.
Deep and Liquid U.S. Real Estate Markets Offer Safe Haven
U.S. commercial real estate with its deep and liquid markets potentially stands to benefit from the ongoing global market turmoil and continued search for global yield. The domestic economy is undergoing a cyclical rebound with consumers more upbeat about the future and hiring slowing but still robust. Potential negative implications for U.S. real estate largely stem from Brexit-driven slowdown of the economy and the negative impact on rent growth. We believe the U.S. economy has the resilience to grow through this current phase of global volatility but will be watching closely for signs of economic contagion from this most recent global challenge.