Of ZIRP, Foreign Investment & Negative Interest Rates: A 2016 Forecast

Zirp GraphBy: Thomas M Brophy

Thomas M. Brophy, ABI’s Director of Research, looks at a number of factors set to impact the commercial real estate market in 2016 and beyond and include: the Federal Reserve’s interest rate increase, modification of the 1980 Foreign Investment in Real Property Tax Act (FIRPTA) and negative interest rates in Europe :

I, much like most of you, have read many market forecasts for 2016 over the last few weeks. Most of these forecasts are predominantly optimistic about commercial real estate, as a whole, through the better part of 2017. Basis for optimism is routed in several areas the most salient are: (1) Fed’s move to increase interest rates 25 to 50 bps over the next year reflects Fed confidence in sustained economic growth and (2) continued employment gains across most of the country. Rather than argue the pros or cons of specific market predictions, I would like to posit an alternative forecast/market overview I have only seen referenced in a small host of articles/publications.  One such publication, heavily referenced below, which has become an important part of my weekly reading is John Maldin’s Thoughts from the Frontline free, weekly newsletter.  Although I do not agree with all his commentary, I most certainly respect his thorough analysis of various macro/micro-economic trends and how they relate to the market.

ZIRP
For seven years, spanning two presidents and two chairpersons, the Federal Reserve kept its official interest rate policy effectively at zero; that policy ended on December 20, 2015 when Yellen & Co. officially increased its benchmark interest rate to 0.25%. Despite this long overdue increase former Dallas Fed President, Richard Fisher, in an interview with CNBC stated, “what the Fed did, and I was part of it, was front-load an enormous market rally in order to create a wealth effect….[as a result] an uncomfortable digestive period is likely now.” (View the full video of Richard Fisher’s interview here please note that this is a raw feed and is a bit glitchy but contains important elements left out of the high quality video posted by CNBC).

John Mauldin, of Mauldin Economics, in his 12/20/15 Thoughts from the Frontline newsletter states that ZIRP (Zero Interest Rate Policy) has distorted and transformed the financial markets in countless ways. Mauldin goes on to state, “remember when we had a risk-free rate of return? We used to regard the 30-day Treasury bill rate as a benchmark [Treasury bills used to yield 5% as recently as 2006, see chart below for historic trends]. If you could make 5% on your money with no risk [equivalent to a 2006 Treasury bill], any manager who only delivered 3% would have to polish his resume.” After 7 years of ZIRP a 5% minimum return is looked upon as absurd. We have now entered a new investment era which Mauldin coins as The Age of the Guessing Game.

Zirp GraphForeign Investment
Just before Christmas, and buried in the $1.1 trillion spending bill passed by Congress to avoid a government shutdown, was a provision modifying the 1980 Foreign Investment in Real Property Tax Act (FIRPTA). Essentially, foreign pension funds will now be treated, for both legal and tax purposes, as their domestic counterparts in real estate investments. According to Bloomberg Business:

“FIRPTA has historically made direct investment in U.S. property a non-starter for trillions of dollars worth of foreign pensions,” said James Corl, a managing director at private equity firm Siguler Guff & Co. “This tax-law modification is a game changer” that could result in hundreds of billions of new capital flows into U.S. real estate….The new law also allows foreign pensions to buy as much as 10 percent of a U.S. publicly traded real estate investment trust without triggering FIRPTA liability, up from 5 percent previously….Cross-border investment in U.S. real estate has totaled about $78.4 billion this year, or 16 percent of the total $483 billion investment in U.S. property, according to Real Capital Analytics Inc. Pension funds accounted for about $7.5 billion, or almost 10 percent, of the foreign total, according to the New York-based property research firm.

Negative Interest Rates
Concurrently, albeit less talked about in the media, was Mario Draghi’s, President of the European Central Bank (ECB), lowering of interest rates into negative territory at the beginning of December, (0.30%) to be exact, and the ECB’s promise of extended QE (Quantitative Easing) well into 2017. (For those unfamiliar with QE, click on the following link for an easy-to-understand video on QE, although published in 2010 its relevance transcends time, Fed governors and market mania.) Despite Draghi’s lowering rates into negative territory, and all but ensuring the continued easing of monetary policy, the market promptly plunged with the German DAX leading the way loosing (4.5%) and effective interest rates on bonds, across the European Union, rose.

Why did this happen, posits John Mauldin in his Thoughts from the Frontline, 12/6/15 newsletter? One, and especially disquieting, is Draghi’s admission of conducting secret meetings with large hedge funds and banks prior to making public statements. Despite his admitted collusion, what this episode lays clear is that interest rates will continue to push negative well into 2017.

Additionally, David Zeros, chief market strategist for Jefferies & Co, via Mauldin’s Over My Shoulder series, says people should pay particular attention to the Swiss National Bank’s (SNB) upcoming policy decisions. It should be noted that the SNB was the original negative interest rate trailblazer with its first decision into negative territory at the end of 2014. Mr. Zeros believes that Draghi’s ECB will follow SNB’s continued path into negative interest rates. “How low can they go?” states Mauldin. “At some point it is more cost-effective to build your own vault and store cash than to pay your bank negative interest for the pleasure of keeping your money. David [Zeros] thinks (1.25%) deposit rates – or even lower – are feasible.”

2016 Forecast
2016, for all intents and purposes, should continue to see high investor interest for commercial real estate particularly multifamily. Despite the Fed’s nominal increase, foreign capital, once limited by FIRTA now let loose, will continue to flee Europe and China for safer harbors in the West. Although there is some evidence of this in recent Phoenix/Tucson Metro multifamily transactions there is by no means enough to consider it a trend. If David Zeros is correct, and ECB interest rates continue downward, I suspect the effects of capital flight will first be seen in private development, as developers will be offered more favorable terms on equity potentially off-setting nascent Fed interest rate increases.

Although many in CRE are choosing to believe the Fed’s interest rate increase as a sign of a strengthening economy, I would assert, in agreement with Mauldin, we’re more likely to see a decrease back to 0% than we are to breach 2.5% or 3%.  However if my assertion is wrong and the Fed continues with rate increases, it would be reasonable to expect that sellers of buildings financed with longer term, assumable debt, i.e. 10-year fixed or better, to be in a better sell condition and command a higher price.  Despite the Fed’s assumption of no recession likely through 2019, with history as our guide, we have now entered into the third longest “recovery,” lacking as it may be, following a Recession/Depression since WWII. If we concede that we are now in Mauldin’s, Age of the Guessing Game, investors must now choose their risk (equity, stock, hedge fund etc) considering that zero risk Treasury bills no longer exist. The question now, what risk will investors choose to take?

As the effects of Dodd-Frank reverberate through the financial system, bonds were the biggest 2015 looser stifled by the effects of the newly minted Volcker Rule which has, rightly or wrongly, evaporated liquidity from the market. Although private hedge funds can, and have, limited this downside by locking out capital withdrawals to specified time periods, barring any material changes, instability shall rule bonds well into the future.  As previously covered in the ABInsight article, Dodd-Frank Financial Reform Act Impacts, and aside from the Volcker Rule, Dodd-Frank will continue to harm the mortgage market in a host of ways thus limiting single-family home market recovery.  Whereas the single-family market will continue to struggle, investors will continue to aggressively pursue multifamily as the tectonic shift from an ownership society to a renter society continues to transform post-Recession America.  This transformation is one we have alluded to in a previous article, Phoenix Metro Rental Housing Boom Explained in One Chart, although the chart is Phoenix Metro specific, skyrocketing rates of renter household formation are being felt across the country.

Lastly, the stock market, a main benefactor of loose monetary policy, has witnessed many public companies buying back millions of shares on cheap credit to boost investor margins. Despite attaining highs, the stock market is still rife with volatility as seen in the opening sessions of 2016. This leads to a topic we have covered in various articles and that is the rise of Private-Credit Lending, aka Peer-to-Peer, Crowdfunding, etc. As banks have been dislodged, whether by government fiat or market conditions, from traditional lending patterns private companies have aggressively filled in the space. Expect even greater expansion of this space as investors, hungry for yield, pile money into this category. Interesting tangential question, what happens if we truly do see a massive expansion in Private-Credit Lending and a concurrent downturn in the market, especially when you consider Private-Credit is not directly influenced by Federal Reserve moves?

To read Brophy’s complete report click here.