Why Real Estate Can Be Attractive When the Stock Market is Volatile
By Scot Eisendrath, Managing Director
The financial markets have been marked by volatility for the past six months – volatility to the downside at the end of 2015 and into the beginning of 2016, and volatility to the upside more recently. A common gauge of stock market volatility is the CBOE Volatility Index (the VIX). The VIX measures the market’s expectation of near-term volatility, and is known to reflect investors’ fears. As the graph below indicates, 12-month volatility and investors’ fears peaked at above 40 in September 2015 and still remain at elevated levels. (The VIX reached 80 during the heart of the 2008 financial crisis.)
Source: Chicago Board Options Exchange
The primary factors that have led to this volatility include slower growth in China and a plummet in the price of oil. Apparently, investors have woken up and now understand that China will not have 10% annual economic (gross domestic product or GDP) growth for eternity. Last year, China grew at 6.9%, its slowest pace in 25 years, and the Chinese government is now projecting an average of 6.5% growth over the next five years. The price of oil has collapsed more than 70%, from over $100/barrel in June 2014, to $27 in February (at press time, it’s back to about $41/barrel). One would have thought that cheaper gas would be a shot in the arm for the economy, but the markets may be thinking otherwise.
Source: World Bank
Overall though the U.S. economy appears to be doing reasonably well. The unemployment rate has fallen from nearly 10% at the height of the financial crisis in 2010 to below 5% in February 2016 (4.5%-5.0% is considered full employment and indicates a healthy economy; the post-war average is 5.8%). U.S. GDP grew at 2.4% in 2015, and is now at an all-time high of $53,042 per capita. Throw in the fact that interest rates remain at historical lows (and there seems little reason to believe they are going up significantly in the near-term), the economy seems to be in a decent spot. Putting aside the issues in China and the oil market, the fundamentals for a continued strong real estate market seem to be in place.
As during any period of volatility, there are implications and potential strategies to employ to benefit from the situation. Following are four observations on the current state of the real estate market and potential ways to play them:
1. Take Advantage of the Dip in Interest Rates
The yield on the 10-year treasury security has fallen from 2.4% in June of 2015 to about 1.9% at press time, a decline of more than 20%. That’s a big move in a rather short time for longer-term bonds. Additionally, based on the Federal Reserve’s mid-March meeting where they lowered their forecast for 2016 interest rate increases, it appears that short-term rates will not be rising as fast as was once predicted at the beginning of the year. Although lenders have increased spreads a bit, rates on commercial real estate loans have still fallen significantly, making it a great time to lock in long-term, fixed rate financing. That explains the 13% increase in mortgage re-financings from March 2015 to March 2016. Another strategy to take advantage of the dip in rates is to sell stabilized assets that qualify for long-term, fixed-rate financing. The buyers of these types of assets will typically pay a premium in the current market, since they are able to enhance their cash- on-cash returns with attractive financing.
Source: U.S. Federal Reserve
2. There’s been a Flight to Quality, Including in Real Estate
As we’ve seen in the treasury market, during times of volatility there is a flight to quality, which drives down yields. The same happens in the real estate market – buyers push down capitalization rates for well-located, stabilized properties. Many buyers, especially private buyers, seem to get more aggressive on pricing for core assets during times of stock market volatility. Again, this makes it a great time to sell stabilized, core assets to yield- hungry buyers looking for a safe haven to store their cash.
3. Market Selection
Now, we sure wouldn’t want to own an office building in Houston or apartments near the Bakken Shale – or other areas of the country that have been hard hit by the collapse of the oil prices. And we’re not venturing to Flint, Michigan anytime soon – unless it’s to invest in a bottled water plant. However, investing in areas with diversified economies, favorable economic and demographic trends, strong, local universities, supply constraints and high barriers to entry and proximity to transportation corridors, has never been more important.
4. An Opportune Time to Buy Value-Add Properties
During periods of volatility, it’s always wise to follow the old adage to zig while others zag. That applies to real estate as well. In times of uncertainty, pricing may soften for some hairy, value-add assets with moving parts, such as high vacancy, operational issues, required capital investment and legal challenges. Those are the times to pounce. It’s not a time to focus on the short-term blip in the market, but the long-term potential of the asset.
Scot Eisendrath is Managing Director of Pathfinder Partners, LLC. He is actively involved with the firm’s financial analysis and underwriting and has spent 20 years in the commercial real estate industry with leading firms. He can be reached at firstname.lastname@example.org.