The world is girding its loins for the Fed’s first rate hike in close to a decade.
Close to a year ago the overwhelming consensus in markets was for a Fed Rate hike by March of 2015, or at latest June. I went out on what seemed a thin limb at the time and predicted the Fed would not raise rates at all in 2015.
By this time tomorrow we will know for sure, but it is looking like we were closer to the mark on this one.
Since news is going back and forth about what sectors will or won’t be doomed, I wanted to focus on a sector that is traditionally seen as responsive to interest rate changes.
So of course I’m talking about… real estate.
Now, real estate is viewed as the archetypal interest rate-sensitive sector. Both for stocks and physical real estate prices.
It seems only natural that the real estate sector should be sensitive to levels and movements of interest rates. After all it is a capital intensive business that normally involves considerable borrowing from both producers and consumers.
But the impact of interest rates on real estate and real estate stocks is nowhere near as clear cut as we might imagine. Don’t think for a moment that a fed rate hike will automatically be bad for real estate prices and real estate stocks, including REITs.
When I look around the main real estate markets of the world, I see, for the most part, a fairly positive outlook. And I say for the most part deliberately as there are some exceptions.
So far in this post GFC recovery we have not seen the excesses in the real estate sector that we have often seen in the past. And this applies to both the supply side as well as the demand side.
On the supply side, although cost of capital has remained low there has not been a massive surge in building of floor space. Housing starts for example for most developed markets have been on the low side of longer term averages. There has certainly not been a huge run up in office or other commercial development.
The speculative urges that have been very evident in previous recoveries have been less evident this time around.
Why? Well, perhaps the memories of the last blowout are still holding speculators back. Or maybe banks are being a bit more cautious on the lending front. And there is a general unease about the sustainability and rate of growth in developed markets. Deflation lurks around the corner. Real estate markets like a bit of inflation.
So there is little evidence of big oversupply in most developed real estate markets.
On the demand side, recovery is very much in evidence. Buying in housing markets has picked up. Some more than others. Tenant demand, in both housing and office sectors is solid and vacancies generally low. This has led to modest rental upside.
Yields are “sensible” in most markets. I always get nervous when I see rental yields (annual rental divided by price of property) falling well below borrowing costs.
That is not the case today for most developed markets.
Yields have certainly come down in most markets reflecting some recovery in real estate markets. But the yield spreads over government bond yields are still wider than normal.
This is definitely not bubble territory.
So what impact is the Fed going to have on stock markets and particularly real estate stocks, REITs and property prices?
This has been probably the most signaled rate rise in Fed history. A great deal has already been factored into real estate markets and stocks.
In the US, the UK and certain other developed markets, there has been a modest dulling of buying activity in the past few months. Rates, regulatory changes and uncertain growth prospects have led buyers to adopt a slightly more cautious stance.
But there is no shortage of demand out there from sovereign wealth funds, insurance companies and a large coterie of private equity funds seeking reliable yield and some modest capital growth expectations.
Let’s take a quick look at the impact of some previous rate increase cycles in some key developed markets.
The chart below shows the movement of stock prices, real estate stock indices and residential property prices for the 12 months following a rate hike for the US, the UK, Australia, Hong Kong and Singapore going back to 1988.
For the most part equity markets have historically advanced very nicely in the twelve months following rate hikes.
But the performance of real estate stocks is much more mixed.
Overall, in previous cycles it has been roughly a 50/50 call. But volatility of real estate stocks has been greatly more pronounced.
If it is a win, it is a big win, and vice versa.
Residential property prices have typically gone up in the first year of a rate tightening cycle, again, not what conventional wisdom might have us believe.
Figure 2 plots the average market index move for all rate cycles in the key four markets. Two things stand out.
First, all markets, on average, have been soft and to the downside in the weeks following the first hike.
Second, markets for the most part have ended the twelve-month period up from the time of the first hike.
Yes, we all know that history does not necessarily repeat itself. Still it can be foolish to totally ignore what past trends can teach us.
History suggests that we should be a little underweight equities, and real estate stocks, going into the rate hike cycle…
… but we should be open to increasing our positions again a little further down the track.
In markets such as the US, the UK and parts of Europe, we do not expect that this Fed hike will derail a modestly recovering real estate sector.
But we do expect to see downside risk to residential real estate prices in both Hong Kong and Singapore in the coming year.
This is being driven more by increased supply, and a weaker economic outlook than by interest rates. This is not a crisis event, as was the case in some previous down cycles. It is a response to local supply/demand forces.
Residential prices are already trending down in both Hong Kong and Singapore, and I expect will continue to do so through most of 2016.
Developer stocks have underperformed in 2015 and at this point I see little reason to expect a sudden reversal of performance.
Hong Kong’s office market will fare much better. Ultra low vacancies will drive prices and rentals modestly higher through 2016. Stocks of major office landlords should outperform, so keep an eye out.