Todd Briddell, Chief Executive Officer and Chief Investment Officer of CenterSquare Investment Management, discusses the interest rate sensitivity of real estate investments
Overview
Since 1999, REITs have outperformed broader equities in the three months following a central bank raising of interest rates
Interest rate sensitivity of real estate is dampened by countervailing economic factors that also affect real estate returns
Low interest rates may spur new development into an oversupply situation
Gateway cities are especially exposed to asset repricing in a rising interest rate environment
Executive Summary
Real estate investments are not as interest rate sensitive as commonly believed, but continued low interest rates induce significant risk due to new development and rising rates, said Todd Briddell, President and CEO of CenterSquare Investment Management, in a recent interview.
Although all investments are interest rate sensitive at some level, Briddell said, since 1999 REITs have outperformed broader equities in the three months following a central bank raising. The reason for this outperformance, Briddell said, is that REITs and real estate aren't just interest rate sensitive; they're basically economic-sensitive. The economics of real estate encompass three drivers—and interest rates are just one of them: fundamentals, such as supply, demand, occupancy, rental rate, and cash flow; capital markets, namely equity and credit spreads; and government policy including fiscal, regulatory and monetary policy. Short-term interest rates represent only a portion of the overall equation.
However, low interest rates have an unintended consequence in that they spur new development. Briddell views the first wave of development in 2015 through 2017 as responding to good fundamental demand for those buildings. However, Briddell worries that if interest rates stay low, credit markets will ultimately lend into construction, and more developers will line up to build assets and to build properties in particular markets. Four to five years from now, that may cause a supply shock as developers all deliver properties—motivated by building a spread to what investors would be willing to pay—at the same time.
Transcript
Zell/Lurie: Real estate in general and REITs in particular are thought to be interest rate sensitive by most investors. What do you think about the risks of investing in today's REIT environment?
Todd Briddell: I think all investments are interest rate sensitive at some level. Real estate, along with industrials—REITs in particular—tend to get a lot of focus because they are forward-leading and forward-looking, relative to private real estate, which only gets appraised on a quarterly or perhaps, annual or semi-annual basis. So REITs get that focus. I think in the last couple of years, looking at the REIT movement, what you've seen is REIT sell-off in anticipation at times of the fed tightening. I think the concern folks have is that an increase at the short end of the curve may end up impacting the long end of the curve. That's the sentiment that exists. When fed policy looks like it's going to tighten, REITs look like they are going to basically be selling off. The facts are, however, if you go back to 1999 through today and you look at how REITs have performed in the three months after central bank tightening, REITs have outperformed not only on an absolute basis, but they've outperformed broader equities in the three months following a central bank raising.
And what this reveals to us is that REITs and real estate aren't just interest rate sensitive; they're basically economic-sensitive. REITs in real estate are lagging indicators. The better the economy does, the more likely there will be positive absorption in a particular market. So I think the positive returns that we see going back to 1999 reflect the fact that there's more to the story than just interest rates increasing at the short end of the curve. There's really a question of, is that increase consistent with economic growth? And equally important, what happens on the long end of the curve? So when the ten-year treasury rate moves up, I would expect that long-term investments tend to perform less well.
Now the question I think that exists at this moment in time in October 2015 is: What will happen as Janet Yellen increases interest rates on the short end of the curve to the long end of the curve, namely the ten-year treasury rate? And I think the common wisdom today is that rates would, on the ten-year, move up consistently and parallel with a short-end increase at the fed funds rate. However, it is possible and potentially likely that an increase in the feds funds rate may be seen as a policy mistake—and a policy mistake given weakness in growth in other parts of the world. And therefore, the ten-year treasury bonds may end up rallying ten-year treasury rates moving down in the face of an actual fed tightening.
So that's a complicated story and I think the best way to think of it is that there are really three drivers of real estate. It doesn't matter how complicated things get, we try to break things down into these three consistent buckets.
The first is the fundamental bucket. Supply, demand, occupancy, rental rate, cash flow. That's an easy bucket.
The second is capital market bucket—basically, how is debt and equity priced, namely equity and credit spreads.
And the third is basically government policy. And government policy includes fiscal, regulatory and monetary policy.
In those three buckets, interest rates at the short end of the curve are only in one of those buckets and it really only represents a portion of the overall equation as to how real estate gets priced and the way that investors feel about REITs and real estate as an investment.
I think you can get a lot of this wrong. And what we see today, not to go too long on your question, but what we're seeing is a lot of investors blinded to risk and to opportunity because of their short-term focus on the fed action.
All right, how are they blinded to risk? They're blinded to risk because over an extended period of time, where interest rates stay low, as they have for the last six years—and perhaps they will for an extended period of time—this may end up causing an unintended consequence. And the unintended consequence that we're paying attention to is: What does this mean for development? The first wave of development that we're seeing in 2015 and '16 and maybe into '17 is demand and supply of buildings where we think that there will actually be good demand for those particular buildings.
However, if interest rates stay low, we think that the credit markets will ultimately lend into construction, and you'll see more developers lining up to build assets and to build properties in particular markets. And you only need to look at the Boston apartment market or the Washington, D.C. apartment market or everything in San Francisco right now to see what it means when you're basically adding new supply.
So we worry about basically a Year Four to Five risk of interest rates staying low and that actually causing a supply shock as developers are all thinking at the same time, that they can deliver properties at a spread to what investors would be willing to pay. So, long story short, remember the three buckets.
Zell/Lurie: In the U.S. private real estate market, CenterSquare has taken the position that primary market core assets are overpriced at the moment. Where do you see the best combination of pricing and growth potential?
Todd Briddell: We're a relative price buyer, so we want to look at relative price. I think relative to core gateway city assets that are owned in the private markets, we can acquire those investments in the public REIT market at a meaningful discount to private real estate valuations. So were I a portfolio manager running a large institutional pool of capital, I would certainly want to have exposure to core real estate, but if I could buy it today, I would prefer to buy it less expensively and at a discount and I can do that in the public REIT market today. That's one thing, relative price.
The second thing is really simple bond math. And the way the bond math works is—we talked about interest rates and the potential for the long end of the curve to move up—if the long end of the curve does move up, then we would expect those assets that have the lowest cap rates—100 basis point move from 4 percent to 5 percent is much more damaging to asset value than a move from 6 percent to 7 percent. And so, the simple bond math makes those gateway city core assets potentially more at-risk in an environment where interest rates move up. So we're concerned about it from that perspective. And look, at the end of the day, if you just simply look at it based on flow of capital, you've seen tremendous flow of capital into those assets and we think that there are some better strategies and some better relative pricing if you look where investors are not all crowded at the door to get in.