In 2002, Daniel Kahneman won the Nobel Prize in economics for his work in a subfield called “behavioral finance.” This field, which Kahneman pioneered (along with Amos Tversky and Richard Thaler) in the late 1970s, attempts to explain why economic decision making often differs from what the neo-classical theory suggests “rational actors” should do.
One of the key takeaways of behavioral finance concerns how investors perceive and manage risk. The prior theory of “rational expectations” claimed that investors accurately discounted future events and did not leave money on the table. However, behavioral finance posits that the fear of loss is more powerful than the prospect of gains. Psychological barriers like this may help explain how investor “risk premiums” seem to vary over time, while the rational expectations theory would argue that investors’ required returns should be time invariant. One of the several risk premiums that have been identified is the so-called carry premium, defined as the yield spread on commercial real estate to the risk free rate (i.e., short-term U.S. government debt). The carry premium for core real estate today is currently at an attractive level.
Behavioral finance research suggests that contrary to the random walk theory, market sentiment, luck and noise drive near-term fluctuations in prices. Meanwhile, fundamentals and market insight are the keys to long-run returns. Thus, investors should avoid reading too much into the daily noise surrounding the markets and instead focus their attention on the long run. Consider that:
- The probability of a U.S. recession in the near term remains low and short-term risks to commercial real estate are muted.
- Core real estate’s strong carry premium remains an attractive investment compared with traditional risk-assets and cash.
- Investors can take advantage of current fear over the prolonged market cycle and negative market sentiment to find attractive entry points for long-term investments.
One common investor fear today concerns the current economic cycle. This fear usually comes with the view that the current expansion is 96 months old, compared with a post-war average length of 60 months. However, economic expansions do not have an expiration date; expansions end because of built-up imbalances in the economy. A recent economic letter from the Federal Reserve Bank of San Francisco underlined this point, summing up its findings: “… based only on age, an 80-month-old expansion has effectively the same chance of ending as a 40-month-old expansion. Therefore, the current recovery is no more likely to end simply because it is approaching its seventh birthday.”
There are currently no signs of structural imbalances building within the domestic U.S. economy. Hopes continue for the new U.S. administration to support growth through fiscal policy. While interest rates are now broadly expected to increase over the near term, higher interest rates do not necessarily translate directly into higher cap rates, and even if cap rates rise, higher economic growth should translate into higher NOI growth offsetting any negative impact on values from higher cap rates. Household debt burdens remain low, while incomes are rising at a faster pace than inflation. Favorable labor dynamics are keeping consumer confidence high. In the corporate sector, fundamentals appear to be improving with the drag from a stronger dollar and the steep drop in energy prices abating. With these headwinds fading and the “profit recession” over, these factors should support additional corporate capital spending and may boost overall productivity. While corporate debt appears high relative to GDP, the duration of this debt and low yields make it seem more manageable. Moreover, corporate debt as a percentage of corporate assets remains low.
Homebuilding, historically a long-leading indicator of the economy, continues to trend upwards with a favorable demographic tailwind of the millennial generation supporting additional growth. Finally, while lending standards are tightening for corporates and commercial real estate, broadly speaking credit creation continues to be supportive of growth but not excessive relative to GDP. The accompanying chart titled “Leading Economic Index,” with data from the Conference Board, summarizes that the year-over-year change in the index has historically provided an early warning, usually turning negative at least one year before the start of a recession.
HIGH CARRY RETURN
The case for holding real estate over the long run is well known. Since 1992, real estate has outperformed cash (proxied by the yield on 90-day Treasury Bills) by an annualized rate of 670 basis points on a total return basis. For real estate, 78 percent of this total return is derived from the income component.
However, while the case for real estate over the long run seems strong, another concern shared by many market participants is that current real estate prices are near peak and nominal cap rates are at or near historical lows. The case for core commercial real estate stems from the attractive carry premium that core real estate provides relative to other asset classes, such as stocks and bonds. Carry is an investment term originally used by currency traders to describe the strategy where they would borrow money in one currency with a low interest rate and invest in another with a higher interest rate. Research has shown that the carry return, which is defined as an asset’s return assuming that prices remain the same, is predictive of future returns across many asset classes. Conceptually, the version of carry used here is equal to the more familiar concept of the yield spread.
To calculate the carry return for real estate, we take the trailing 12-month income yield and subtract out the 90-day U.S. Treasury Bill yield (used as the return to cash). Historically, the yield for real estate averaged a 470 basis point spread to the cash yield. With cash yielding 1.0 percent today and core real estate yields at 4.7 percent, the carry premium for real estate is currently 370 basis points, still only 100 basis points, slightly below its historical average.
CORE INVESTORS FOR THE LONG RUN
Short-term price fluctuations are extremely difficult to predict and represent more noise than signal. Instead, investors in core commercial real estate should focus on a seven- to 10-year investment horizon where asset selection and manager skill will ultimately drive returns. Rather than reacting to negative sentiment shocks, it is preferable to utilize temporary sentiment-driven market weakness as opportunities to enter at an attractive price. This is particularly true in today’s investment environment where carry is favorable and the case for a prolonged fall in real estate prices appears weak.
If we assume that NOI increases by 3.4 percent over the next year, real estate would be expected to outperform cash by 520 basis points. Therefore, investors who are switching to cash over real estate are making the assumption that real estate prices must be poised to fall by at least 3.8 percent. For this decline to occur, cap rates would need to rise by 30 basis points over the next year. For reference, CoStar forecasts that cap rates will increase by just 10 basis points by the end of 2017.
Tony Charles, Margaret Harbaugh and Stephen Siena are executives and part of the real estate research and strategy team at Morgan Stanley.