Realty can take interest rate hikes in its stride

Listed real estate companies and investment trusts have not fared well in recent weeks — the combination of global market turbulence and prospect of higher US interest rates has driven down public property plays about 20 per cent.

Release of the most recent deliberations from the Federal Reserve suggesting there is little reason not to finally raise rates may well further spook the market for these counters. Since the Fed’s quantitative easing policies were all about inflating asset values, including the value of real estate, (BlackRock’s iShares high quality Reit index was up 30 per cent last year) many analysts think a correction is due as those policies reverse.

Executives at real estate investment firms, though, are confident that values do not have much further to fall and are far less vulnerable to the threat of rising rates than the naysayers assert. They note that the positive signals in the two Fed variables, job growth and inflation, are good for real estate and more than enough to offset any drag from a modest rise in rates.

“We have been running our business with the expectation that interest rates will increase, particularly in the US; in fact, we welcome this. Interest rates will rise because the economy is improving and that is positive for business,” Brookfield Asset Management told its shareholders at the end of the second quarter.

“Returns may be slightly less going forward, but cap rates [the inverse of the return] have been stubbornly high relative to interest rates for one specific reason... that everyone knew interest rates were going up.” At the same time though, the letter noted, “we have been net sellers of assets in the US, given the robust amounts of capital available to investors”.

The macro outlook is also supportive, particularly for the residential market. “Residential investment is on pace to grow at a solid 9 per cent rate this year. We are trimming our expectations for 2016 slightly — lowering our forecast for residential investment to 8 per cent from 11 per cent previously — but we still expect housing to be the top performer among the major components of GDP,” a new report from Goldman Sachs notes (despite choppy housing starts — including an 11 per cent decline for October).

Moreover, the public market and private market today diverge significantly in their assessments of current value — a disparity that was seen recently in the market for tech and internet companies as well. The private market has not traded down nearly as much as its public counterpart. Firms including Blackstone and Brookfield are now looking at taking advantage of the discrepancy to take listed companies and investment trusts private.

Both have so much cash that they will effectively put a floor on both Reits and public companies, analysts say. “They are trading at up to a 20 per cent discount to net asset value,” says Bob Steers of real estate investment firm Cohen & Steers in New York. “It is like buying dollars for 80 cents.”

In addition, analysts dismiss the idea (held by some Fed governors among others) that there is anything like a bubble in some real estate sectors where prices have risen particularly dramatically, such as the market for commercial property. If prices are high it is because of lack of supply, they say, in contrast to 2007.

“At that time buyers were making acquisitions with levered money,” says Bruce Flatt, head of Brookfield. “Today, it is all equity capital, not debt.”

And finally, there is a relative argument to be made in favour of real estate. “Real estate is TIPS (Treasury Inflation Protected Securities) on steroids,” adds Steers. “Reits are not bonds. The most certain thing is that if rates are rising and you are in fixed income you will lose money.”

But what if the Fed is wrong and any rise in rates is less because the US is recovering and more about other factors? In fact, many observers have been bewildered by the insistence that the US is recovering when it has been unable to break out of the 2-2.5 per cent range in economic growth and a big part of the explanation for the drop in the jobless rate is because so many people have dropped out of the market.

Wage increases remain disappointing. Retail sales as the holiday season nears have been disappointingly soft.

In that case, the argument that other investments will be even poorer performers is cold comfort.

Financial Times