Thus far in 2019, the long end of the sovereign yield curve across major economies, including the UK, Eurozone, US, and Japan, retreated. Interest rates are once again commanding investors’ attention given the recent slowing of the global economy that is supported by quantitative easing and ultra-low interest rate policy. In retrospect, the future of interest rates demands careful thought considering the Fed deployed nearly $3.5 trillion dollars of QE, in combination with ultra-low policy rates, to impose guidance. Now that the U.S. Fed is trying to unwind its $4 trillion balance sheet and remove the figurative training wheels from the economy, it has become more challenging to interpret the yield curve and predict interest rate movements solely from market forces. In real estate, which has bond-like characteristics, there is a focus around the path of interest rates and ultimately the impact on the asset class.
Building a View on Long-Term Interest Rates
Demographics & Productivity Growth
Population and productivity growth are currently the major limiting factors related to long-term GDP growth expectations. The U.S. and other developed nations are structurally challenged by large, aging workforces and lackluster population growth. The conditions that facilitate population growth do not seem to be improving. Marriage rates continue to decline, with financial instability being cited as a major reason for avoiding marriage among lower-income adults. The overall economic recovery in the U.S. has been unbalanced, with high-income earners being the primary beneficiary of wage growth and a tight labor market. Given tepid expectations and economic conditions that are not facilitating additional population growth, we must look to productivity growth to spur higher levels of economic growth. However, productivity growth has been underwhelming since the 1990’s, when the advent of mobile computing, phones, and the internet produced rather large gains. With lower expectations of productivity growth and population growth going forward, overall economic growth expectations are more moderate than historically considered normal. Because the long-term sovereign yields are linked to GDP growth, it would conclude that tempered growth expectations translate to lower rates.
Globalization & Automation
Technological innovation and labor-replacing automation have reduced long-term inflationary forces. Globalization has enabled companies to quickly adapt supply chains to the most cost-effective choices. Considering that labor as an input is generally automatable, automation only serves to further undercut inflationary pressures in combination with globalization. In a tightening labor market typical of today’s developed economies, where we historically would have expected to observe inflation, we have yet to see sustained core inflation. With globalization and technology undercutting inflationary pressures, the nominal interest rates are being reduced as well.
Real Estate in a Low Interest Rate Environment
Given the expectation that interest rates will remain lower for longer, real estate as an asset class stands to benefit. Cap rate yield premiums sit in a relatively healthy place in comparison to 10-year sovereign yields. Leverage remains accretive, particularly in continental Europe and Japan, where high single-digit income yields can be generated with 50-60% leverage. Long duration leases, typical in the Triple Net and Medical Office property sectors, stand to benefit from the potential for additional cap rate compression. Outside of the higher yielding sectors, we continue to look for growth driven by secular trends. For example, e-commerce is reshaping the industrial sector, which is benefitting from the change in consumers’ preferences. Also, there are other trends such as the globally aging population and increasing internet/data consumption that real estate stands to benefit from over the long term.
In the face of an uncertain economic environment, real estate benefits from stable income generation. The income generation has historically accounted for over 70% of the total return on real estate. Furthermore, the stability of income generated by real estate can be levered by low-cost debt in a low interest rate environment. Investors can defensively position real estate by focusing on investments generating a substantial portion of the projected return from income and avoiding deals with binary risk (e.g. delivering new condos into a less favorable economic backdrop). Further, real estate benefits from the ability to roll rents to market during periods of rent trending upward. These characteristics of real estate give the asset class some defensive characteristics that make it attractive in an uncertain environment.
Taking a step back, the fundamental factors driving interest rates appear to be supportive of long-term rates remaining low relative to historic norms. More moderate productivity and population growth support the notion of lower GDP growth, and thus lower real interest rates. Technological innovation and labor-replacing automation have lowered long-term inflationary pressures, which should result in lower nominal interest rates. We believe this combination of structural headwinds will anchor longer-term nominal interest rates. Real estate stands to benefit from lower interest rates because it continues to generate a yield premium relative to bonds, benefits from accretive leverage, and retains its ability to capture rental growth.
This summary has been prepared solely for informational purposes at your request and is not to be construed as investment advice or an offer or solicitation for the purchase or sale of any financial instrument. Townsend’s views are as of this date of this publication and may be changed or modified at any time without further notice. Past Performance is no guarantee of future results. Investing involves risk, including possible loss of principal. While reasonable care has been taken to ensure that the information contained herein is not untrue or misleading at the time of preparation, Townsend Holdings, LLC d/b/a The Townsend Group (“Townsend”) makes no representation that it is accurate or complete. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.