Is the Fed’s Uncertainty a Boon to Commercial Real Estate?

This is an exclusive commentary from Richard W. Chichester, president and CEO of Faris Lee Investments. The views expressed here are the author’s own.

Rick Chichester, President & CEO

Rick Chichester, President & CEO

All eyes are on the Fed. We are seven years into an economic recovery, the fourth longest expansion in history, and the Federal Reserve has only managed a single rate hike. This continuation of loose monetary policy comes with increasing risks that could have harsh implications. Target (core) Inflation has not met the goals of the Fed’s liberal monetary policies, but it has created asset inflation, with the price of property (residential and commercial), equities and bonds more than 50% higher, globally, than seven years ago. Additionally, the stock market is reaching new highs, but the underlying fundamentals of the economy are not indicative of the current pricing we see in much of the market. Approximately 50% of the stock market’s demand is centered on corporate share repurchases, which is the financially engineered method to increase earnings per share (EPS), and this is made even more attractive due to the extremely low cost of debt. Also, of the $1.8 trillion held in cash in US corporate accounts, half of it belongs to only 25 of the 2,000 companies tracked by the S&P global ratings, and other than the top one percent, corporate cash has been declining and debt has been rising. In a search for yields, investors have been taking extreme risks that at some point will not be rewarded and could lead to a significant correction—low rates push returns on cash lower and cause the price of income-generating assets to rise.
In this unprecedented new normal of low rates and low core inflation, what is an investor to do?
There aren’t many attractive answers to that question right now, but real estate is one of the few. It is highly attractive as an investment because it can provide stable, long term yields. Of course, all real estate is not created equal and therefore a carefully crafted investment strategy is critical to success. To this end, consider not only where to invest, but also what type of property to invest in.
When executed with discipline, retail real estate provides some of the best risk adjusted returns. Consider the fact that personal consumption drives approximately 70% of economic activity, making retail a cornerstone of the economy and retail property a critical distribution channel. As much as the internet has had an impact, many retailers have adjusted very well, and new concepts are flourishing. With active, operational discipline, multi-tenant retail can survive and thrive in all market cycles. For more passive investments, single tenant NNN continues to grow in demand. However, with both asset classes and today’s strong valuations, the fundamentals of real estate are now more important than ever — location, location, location. Good real estate is far more important than tenant credit and/or lease term.
The primary, near term challenges for real estate are the capital markets. The risk-retention regulation of Dodd-Frank is soon to be implemented, with sponsors now required to reserve at least 5% on their balance sheet. This impacts the CMBS market as the sponsors are pricing their risk in ways similar to the B piece, causing for higher interest rates. As well, there is a liquidity issue. With regulation up, rates down, and widening of credit spreads, there is the suggestion of weaker demand in the secondary market on which lenders depend. Unnatural monetary policy and restrictive regulations are a potential threat to the mortgage market.
In this new normal of low rates and low core inflation, real estate will continue to provide an excellent risk-adjusted diversification strategy. In fact, finance luminary and “bond king” Bill Gross recently called real estate, along with commodities silver and gold, a better investment than US bonds. All in all, it is a good time to consider strategically increasing your real estate investment exposure, but with a keen awareness that we are in a period of making history, not repeating it, and all real estate investment should be approached with an unprecedented level of vigilance and scrutiny.

FARIS LEE NEWS

Subscribe to receive news direct to your inbox.

Copyright © 2019 Faris Lee Investments