Puppy Dogs, Rainbows and Three Caps

A nation’s overall happiness is not necessarily based on the strength of its economy.

Take Japan, for example. Its economy hasn’t grown much in almost 30 years, but it has one of the highest standards of living in the world and, according to a recent study by the CATO Institute, is the third “least miserable” country on earth. The U.S. is the 28th least miserable out of 95 countries ranked by CATO, which derives the rankings by the sum of each nation’s unemployment, inflation and bank lending rates minus the percentage change in real GDP per capita.

As I turn 50 this year, I’ve begun to think a lot more about things money can’t buy: more time with my kids, a decent first baseman on the Baltimore Orioles and the pursuit of happiness. I also wonder what’s happiness worth? While happiness is great, it may be a bit overrated. Based on seven independent studies, happiness peaks at the ages of 16 to 18 and 86 to 88. Everyone else—and this means you—is pretty much at the nadir of miserable for most of their lives.    

So, what is happiness worth? The eternal sunshine of the spotless mind, ignorance is bliss and happiness is a warm gun (thank you John Lennon) all sound pretty good to me and sound even better as I get closer to my 86-year-old fountain of new happiness! And if happiness is measured by cheap stuff (i.e., a $500, 68-inch smart TV) and more free time, then 2019 is a good year. Technology and innovation have made all stuff cheaper (though services costs have skyrocketed) and many big employers are experimenting with four- and even three-day work weeks as knowledge-worker productivity has increased.

The problem is that the same forces that are increasing our happiness—particularly innovation that, due to efficiencies in things like electric cars, makes us use less stuff—are also slowing economic growth. These four forces are too much cheap money, cheap labor, cheap energy and innovation itself. So we may be happier, but we are in for slow growth, low inflation and low interest rates for a long time. Big deal you say, at least we are happy! Well, I like puppy dogs and rainbows as much as the next guy, but I can’t put them in my 401(k), which requires growth and cold hard cash.

The silver lining to lousy growth is lower cap rates for commercial real estate. In short, because growth has slowed globally, we are in a seemingly permanent environment of lower interest rates and inflation. This lowered cost of debt capital, combined with the increasingly lower cost of equity capital as both international investors and large U.S. domestic institutions increase their allocations to U.S. commercial real estate, means that cap rates can and likely will get lower. U.S. growth may be slowing, but the country’s relatively high-yielding (compared to bonds) commercial real estate is the cleanest dirty shirt in the global investment laundry.

“I can’t believe I’m paying a four cap.” Just wait. European inflation is falling, and the U.S. is following suit. EU cap rates are typically 50 to 100 basis points lower than U.S. cap rates for comparable assets because of lower inflation. Lower inflation ahead means lower cap rates are the latest luxury European export that will line the pockets of U.S. commercial real estate investors in the form of declining cap rates across the board in core markets like New York, Los Angeles, San Francisco and Washington, D.C.   Don’t be surprised when the three cap becomes the new four cap in the U.S.

Jamie Dimon, Alan Greenspan and a lot of other smart folks believe that the 10-year Treasury rate could go to zero to match the $17 trillion of zero or negative interest rate bonds globally. This means commercial real estate investors investors will do well in the years to come. With slower growth, my 401 (k) may be a disappointment in my golden years, but at least I’ll be happy (particularly if I buy a puppy)!

By Spencer Levy, Chairman, Americas Research & Senior Economic Advisor, CBRE.

A Tale Of Two Stress Tests

You don’t often associate an “I told you so” moment with the release of a banking stress test, but I definitely experienced one of those after reading the recent findings of the Bank of England.

Frankly, I had spent the previous few weeks scratching my head after reading the headlines following the European Banking Authority (EBA) stress test, as I was mystified as to why three of the top five biggest deteriorations in capital came from the UK banks; yet, some like the Italian banks were seen as the pillars of the establishment in the capital league tables.

The Bank of England, by contrast, has concluded that UK banks are all well-positioned (to varying degrees) with regards capital provisioning. This being the case, we will explore the reasons why the EBA test, involving the largest 48 European financial institutions covered approximately 70% of EU banking sector assets was perhaps, at best, misleading.

The EBA stress test aimed to examine the resilience of the banks’ balance sheets to a hypothetical economic crisis embodied in severe economic shocks. The hypothetical shocks saw the EU economy shrink by several hundred basis points over a two-year period, with large drops in real estate prices and decades high unemployment levels.

The results indicated that all 48 banks tested had sufficient capital to withstand the economic recession modelled by the EBA. None of the banks dipped below the 5.5% capital ratio threshold that is used by analysts as a de facto failure rate [the EBA test doesn’t have a fail/pass outcome like the Bank of England’s or the Fed’s stress tests].

Although none of the banks tested reached critical capital levels, it was surprising to find UK banks Barclays, RBS and Lloyds accounting for three out of the top five biggest deteriorations in capital over the two-year stress period. The test left Barclays and Lloyds performing worse than indebted Italian institutions and ending up among the three worst performing banks in the test [figure 1]. Barclays was the worst performer out of the 48 banks with its capital ratio reaching a mere 6.37% at the end of the stress period.

The UK was the most affected geography, both in terms of capital deterioration and final capital levels. Even Italian banks performed better in the test than British household names Lloyds and Barclays, with RBS and HSBC not too far ahead. So, why did the UK perform so badly?

The main driver of this poor performance is the economic scenario imposed on the UK relative to the other geographies tested. The economic shocks imposed on each economy were not homogenous across the 15 regions tested i.e. the testing ground is not the same for all the banks. Figures 2-4 show what the economic shocks imposed look like for four main EU economies.

By far, the UK is tested against a significantly harsher economic scenario than most other countries, with the EBA imposing severely recessionary shocks on the UK including a 3% fall in GDP in the first year alone, and a 29% drop in commercial real estate capital values.

Furthermore, the EBA test suffers from “structural” problems and limitations. For one, it only looks at a snapshot of the banks’ balance sheets and doesn’t take into consideration measures that will very likely be taken by the banks to strengthen their capital positions during an economic downturn. This shortcoming of the test was even acknowledged by the EBA’s own top watchdog Andrea Enria, who argued that elements of the test are no longer “tenable” and need a redesign.

It is for reasons such as this that neither banks nor markets see the EBA’s test as on par with other central bank tests, namely the BoE and the Fed. The merit of not taking the EBA’s test too seriously has now been shown by the truer test of the resilience and strength of the UK banking system, as revealed in the results of the Bank of England’s test.

In the meantime, perhaps we should leave the last word to the bond markets, who were not fooled by the EBA results; looking at corporate bond spreads, the market seems to have consistently been of the view that UK banks are far safer and more sustainable institutions than their Italian counter parts, as opposed to the test’s findings.

Bonds selected for spreads:

By Richard Dakin, Managing Director, EMEA, Capital Advisors, CBRE.

More of the Same for Italian Politics?

On December 4, the Italian electorate overwhelmingly rejected the government’s proposals for constitutional reform and Prime Minister Matteo Renzi promptly announced his resignation as a result.

The reform was aimed at reducing the size and influence of the upper house of the Italian parliament and it was one of a number of steps aimed at making Italy easier to govern. Unfortunately for Renzi, the referendum turned in to a chance to register dissatisfaction with the government and Renzi’s promise to resign if he lost only served to encourage the protest vote.

The “no” vote ushers in a period of political gridlock in Italy but this is not exactly a new phenomenon. On average, Italy has had one government each year since the republic came in to being in 1946. What will happen now is that the President of Italy, after some deliberation, will push for the formation of a transitional government to fill the gap until the next General Election is held in spring 2018. There is a chance that this will see Renzi return to office or, if not Renzi, another like-minded technocrat.

The markets are worried about an early General Election that might put the anti-establishment Eurosceptic Five Star Movement (5SM) in a position to form a government.

This is unlikely to happen. An early election is doubtful and, even when one does occur, the lack of constitutional reform could actually make it harder for the 5SM to form a government. It is also worth noting that although definitely anti-establishment, the 5SM is not quite so EU-sceptic or euro-currency sceptic as many foreign newspapers report.

A “yes” vote could have increased the attractiveness of Italian real estate to investors. The “no” vote leaves the old uncertainties in place and layers a few more on top.

Despite the uncertainty, CBRE still expects reasonably robust investment levels in Italian real estate over the coming year for a number of reasons:

  • Domestic investors, such as private investors or pension funds, have a “home-bias” towards Italian property. Increased political uncertainty outside of Italy has actually led some Italian institutions to re-think their strategy of diversifying away from Italy and towards more balanced European core investments
  • Some real estate investment funds are approaching maturity and they will be successfully marketed regardless of the political uncertainty
  • Milan accounts for almost 40% of investment and it is generally seen to have strong economic prospects and to be partially insulated from wider Italian uncertainties
  • Prime retail is also seen as being resilient. It is more dependent on tourist spending and internal demand for the quality retail offer and is less likely to be affected by any fallout from the referendum

In the short-term some yields could move out and there may be some opportunistic buying possibilities, although the level of yields is unlikely to be affected longer-term. The big negative impact short-term is likely to be on the ability of banks’ to dispose of some of their NPLs. The various attempts to re-capitalize the banks all include some element of NPL sale and this will now be harder to do in the post-referendum climate. Continued worries over the solvency of Italian banks, particularly Monte dei Paschi di Siena, rather than political instability, will actually be the dominant concern over the coming months.

We continue to believe that the banks will muddle through and that private sector attempts at re-capitalisation will continue. Discussions with the European commission on how the government can assist Monte dei Paschi di Siena without breaking European bail out rules will continue.

By Neil Blake Ph.D, Head of Research EMEA and Raffaella Pinto, Head of Research Italy, CBRE.

Further information can be found in the CBRE ViewPoint “The Property Market Implications of the Italian Constitutional Referendum”.

QE and the European Real Estate Market

The size of the full Quantitative Easing (QE) recently announced by the ECB has exceeded many expectations.The eurozone’s commercial real estate market should benefit in the short to medium term from the removal of uncertainty around potential interest rate raises and currency fluctuations.

In the text book version, QE leads to more funds being available to banks and to more bank lending. However, there is little evidence of this having happened in either the U.K. or the U.S. when they ran QE programmes and, in any case, many European banks are not short of funds. Rather than having a direct impact on bank lending, the big benefits for real estate from QE come from low long-term interest rates and a more competitive exchange rate.

Lower interest rates push up the value of property through a relative pricing effect (government bonds yield less income so property will be required to yield less. In other words property prices will rise). Low interest rates are also a boost to the economy which will ultimately benefit rental values. A more competitive exchange rate also benefits the economy by boosting exports and by making imports less price competitive and this will also feed through to occupier markets and higher rents.

QE might not be a panacea for low growth in the eurozone but it will not do any harm either and taken together with the fall in oil prices, the eurozone economic and property market outlooks now look brighter than they did only a few weeks ago. To a large extent, some of these benefits are already been enjoyed. Speculation about QE has led to record low interest rates and an expectation that rates will start to increase earlier in the U.S. has led to a euro slide.

The announcement will now serve to lock these benefits in for longer. Long-term interest rates are unlikely to increase much before 2016, and low inflation, driven by falling oil prices, will also help to keep the lid on rates. The euro is likely to to depreciate further in the short-term as markets digest the implications of the announcement though it could then stabilise once the adjustment has been made.

The only potential downside for continental European real estate is if foreign investors start to expect a long-term depreciation of the euro (two or more years). If this happens we should expect to see a discount placed on European real estate by these buyers to compensate for anticipated exchange rate movements. This will offset some of the gains listed above.

So many expectations had developed around today’s announcement that if the ECB had not made a move there would have been severe disappointment and an immediate rise in the euro and the chance of a reversal of some of the recent interest rate declines.

Dr. Neil Blake, Head of EMEA Research, CBRE.