Through the third quarter of 2018, U.S. investment markets were exhibiting a relative calm. Jobs reports churned out steady employment increases. GDP growth delivered in line with analysts’ estimates, and the stock market enjoyed a steady ascent. Volatility in equities was notably absent, as it had been for most of the preceding 10 quarters. It was all enough to leave investors feeling that the markets were behaving rationally and predictably.
This turned out to be a false sense of security as the S&P 500 shed roughly 400 points (14 percent) during the fourth quarter. Volatility returned with 300-400-point daily swings, as investors showed their concerns about an overbid market amidst growing global trade tensions and a rapidly rising interest rate environment.
As we enter 2019, which is more relevant—the underlying forces in the U.S. and global economies that fostered the sense of calm and predictability that prevailed for the past few years or the sentiment that the run is up and investment markets have begun a more precipitous decline? Will potentially improved yields in the stock and bond markets provide competition that depresses property values? Will the “wealth effect” for private investors (aka the “denominator effect” for institutional investors) stem their appetites for commercial real estate investments?
It is inevitable that these forces will lead to cap rate expansion and property value declines, particularly the increased cost of leverage. But how steep will this decline be? After six-seven years of outstanding returns, will property investors seek to preserve gains with a wholesale sell-off as the stock market has been witnessing? Or will the landing be softer and the value declines less dramatic for commercial real estate assets?
Despite competition from alternative investments, the expected drop in property values shouldn’t be dramatic. In fact, the trough might be somewhat shallow assuming that any dip attracts some of the historic volume of capital on the sidelines. An all-time high of $180 billion of dry powder remains earmarked in private equity real estate funds as of 9/30/18, with $70 billion allocated to North America-focused funds. Additionally, the market has not yet seen the full effects of the 2018 tax cuts that provided incentives for passthrough investments such as real estate partnerships and REITs.
The long-term trend for both institutional and private investors alike favors increased allocation to alternative investments. Improved transparency, data reporting and liquidity in these sectors provides greater comfort to investors attracted by the premium yields available in these non-public markets. Real estate is viewed by many as the most efficient alternative investment marketplace, the least alternative or the most predictable alternative. As a result, most domestic institutions are looking to invest a greater share of their assets in commercial real estate over the long run. Furthermore, the ongoing influx of foreign funds into U.S. properties could add to the wave of capital that shores up values and ensures that the price correction is only modest.
Economic fundamentals are still relatively strong while supply and demand are in comparative balance across most property types and markets. This climate remains conducive to long-term value realization in property investments, especially if returns are enhanced by a modest price correction as expected.
Investors should look to profit from dislocation created by 2019 price adjustments, taking advantage of these special situations as buying opportunities in a market that should not experience a steep slide.