Real estate markets warrant caution

In August New Zealand's Reserve Bank cut the official cash rate ("OCR") by 50bps. In September the US Federal Reserve Bank cut the federal funds rate ("FFR") by 25bps. Both banks, in the commentary accompanying their announcements, telegraphed the likelihood of the need for further rate cuts in the coming months.

The economic growth picture implied by these cuts is equally subdued across developed economies. For example in September the European Central Bank ("ECB") announced its "biggest package of rate cuts and economic stimulus" in the last three years cutting the base rate to -0.40% (that's a negative rate) and the reintroduction of quantitative easing at an amount of $20bn per month. Similar conditions are evident in many other countries and the watch-word of central bankers for interest rates across the globe is now "lower for longer".

These rate expectations are having a significant impact on real estate markets, but why and how so? In short if investors want a higher return on their money than the low rates offered by government bonds, bank deposits etc. might provide then those investors must look elsewhere, and their gaze has fallen firmly on the real estate sector. The result is that more investors, ranging from individual "mums and dads" to global pension, life and investment funds, are all putting money into real estate, creating high levels of demand and pushing up prices to levels which generally, in our view, do not fairly represent risk.

Yield compression and convergence are the relevant industry terms; compression being a reduction in the percentage rate applied to a property's income, the method by which commercial real estate is valued (the lower the rate applied to the income of a property the higher the multiple and the higher the value - effectively the inverse of the "multiple" applied to shares): convergence being the difference or "spread" between the "risk-free" rate, such as government bonds, and the return generated by a particular property.

An additional factor affecting compression has been real estate's transformation from being considered an "alternative" asset class to being an increasingly important area of portfolio allocation for money managers. This article is too short to deal with this subject but in brief it means that pension funds, and the like, have been increasing the amount of money invested in real estate in response to, for example, future pension payment obligations. For the past 30 years such investments or "allocations", as a percentage of total investment portfolios, have been under 10% of the total portfolio, however in recent years this percentage seems to have been gradually tracking upwards, and continues to do so, and the amounts involved are huge.

The overall impact of this activity on real estate "value" is there for all to see; from houses to prime office buildings, and everything else in between, values are at historical highs. Fundamental value, or the investment rationale that underpins actual value in real estate, such as tenant covenant, lease term, build quality, location etc seems to have left through the stable door and is now with the horse in the bottom field, leaving behind only a finite bale of low interest rates.

The market is dominated by sales which demonstrate these points - older properties with inferior investment characteristics, such as shorter lease terms or delayed capital expenditure requirements, are now selling at prices previously reserved for much stronger assets.

We would therefore urge investors, especially those driven necessarily to the syndication market, to approach what are relatively illiquid assets with a good degree of caution. Property investment is a time-sensitive exercise so buying assets built on shaky, over-priced foundations, with returns amplified only by the low cost of capital, may come unstuck as interest rates rise and lease terms end.

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For objective opinions on your real estate investment intentions or to learn more about real estate investment opportunities in New Zealand with Tascott & Co please contact:

NEW ZEALAND

Toby Scott, Director

Tel: +64 (0) 27 5299 879

Email: toby@tascott.co.nz

About Toby Scott

Toby has enjoyed a specialist real estate finance career spanning 20 years. In New Zealand Toby managed the funding requirements of some of the larger property investment and development clients across the country, using his structured finance skills to bring many significant transactions to market, supporting clients and their growth aspirations.

In 2014 Toby established Tascott & Co to provide clients with informed and independent views, based on sound risk analysis, on all aspects of commercial real estate investment and financing. At the beginning of 2019 Tascott & Co completed its maiden investment, the $10.200m acquisition of a 6,000sqm mixed use asset, converted from a heritage warehouse.