Are We in Bubble Trouble? | FTI Journal | FTI Consulting

Are We in Bubble Trouble?

Blowing Bubbles

The state of the U.S. real estate market as an investment vehicle shows eerie similarities to the era before the Great Recession. Should we be worried?

If you stop to consider the state of the U.S. real estate market as an investment vehicle right now, you might get a little edgy. Though sales volume and price appreciation have boomed at record levels since 2009, the data shows a pattern eerily similar to the pre-recession period (2001-2007). That has left some real estate professionals and investors concerned that the market may be overheated and being driven by speculation.

You can chill. According to Michael P. Hedden, Managing Director at FTI Consulting who specializes in real estate valuation and solutions, this time is different. “While we are at the same point in time on the trend curve for sales volume and capitalization rates,” he says, “the facts and circumstances indicate solid fundamentals and abundant liquidity are being strategically deployed.”

Hedden points to three major reasons for this phenomenon: more diversified sources of real estate capital, low interest rates, and the advent of big data—the more robust and accurate institutional real estate data sources.

Ready to invest? Here, Hedden shares his perspective on the real estate market’s continuing allure, the possible effects of an interest rate hike by the Fed in the near future, and the power and impact of big data.

Q: From your point of view, what makes the U.S. commercial real estate market so attractive to investors lately?

A: The slowdown in other economies. The United States is not in a recession. We’re growing—slowly, but we’re growing. And from a global perspective, investors like the security of knowing they can make long-term investments in U.S. assets and that they’ll always be able to exit those investments. U.S. property assets can serve as an inflation hedge, are relatively secure, and are less volatile than in many parts of the world.

Q: But hasn’t the global economic slowdown reduced the amount of capital available for real estate investments?

A: On the contrary, I have seen an increase in the capital and allocations to real estate assets by publicly traded REITs, sovereign funds, pension funds, debt funds and insurance companies. There are several reasons for that. First, there is a significant amount of investable capital available—enough to pick up the slack from commercial mortgage-backed securities (CMBS) and regulated financial institutions that may not be lending as actively as they did in the past. The abundant supply of global real estate investment capital, in turn, creates demand for a limited supply of upper-tier opportunities, which causes property values to increase.

Second, the volatility of returns on alternative investments makes real estate seem more stable by comparison. Recently, some industry observers have suggested that investing in tangible assets is prudent given the current economic climate.

Q: Real estate has traditionally been a long-term investment vehicle. Has that changed since the Great Recession?

A: No. Investors are very focused on their exit strategy at the end of their holding period. Many investors, lenders and homeowners lost a lot of money in 2008 and are concerned that it could happen again. Investors are aware that they face a high probability of an economic recession occurring during the holding period on their investments and therefore are focused on the long haul.

Q: Are they right to worry?

A: Some economists have suggested that because monetary policy is keeping interest rates low around the world and providing an abundant supply of money at a time when GDP growth is slow, there’s a distortion in the allocation of financial assets, and many assets are experiencing extraordinary appreciation. You could include real estate among the asset classes that may reverse course when and if there is a significant increase in interest rates that causes investment capital to flow into other more attractive, alternative assets.

But it’s important to remember that at the onset of the Great Recession, the lack of liquidity in the market and the inability to monetize real estate assets was the primary cause for the downward spiral in prices. This time around, we're still flush with liquidity, and interest rates don’t seem likely to move in the near future—and even if they do, they would have to move very significantly to impact the real estate business. Finally, big data allows a level of transparency that didn’t exist during the crisis.

“A modest incremental increase in interest rates should not have a detrimental effect on real estate investment in the short term.”

Q: You mentioned interest rates. What will happen to real estate when and if the Fed finally raises rates a second time?

"A modest incremental increase in interest rates should not have a detrimental effect on real estate investment in the short term."A: A modest incremental increase in interest rates should not have a detrimental effect on real estate investment in the short term. Increases in short-term interest rates affect the real estate debt market less than either an increase in the long-term interest rates that are reflected in the mortgage market or a steepening yield curve. For now, the flow of foreign capital into long-duration U.S. Treasury notes has kept long-term interest rates low, and real estate investors are factoring that reality into their investment decisions.

Over the long term, as mortgage rates revert to their long-term historic mean, capitalization rates will rise—and unless there has been a significant growth in the income of a particular asset, its value won’t appreciate over the holding period. So, the income assets produced will have to increase to preserve capital and serve as an inflation hedge as rates move higher.

Q: Switching gears for a moment, can you elaborate on your point about how big data has changed real estate investment?

A: Advanced software and access to real-time, transparent information allow sophisticated investors to make predictive models that anticipate where real estate values will grow and map those predictions to their strategic business plan. They’re putting the pieces together and connecting the dots in a way that didn’t exist in the past.

Q: Can big data predict a real estate bubble?

A: By definition, I don’t believe you can predict a bubble. However, I do believe that vigilant observation of all the data points that apply to your risk analysis is easier with the analytics that flow from big data.

Q: Two final questions. What are the most interesting markets in the U.S. right now from your point of view?

A: Other than gateway cities such as New York, San Francisco, Los Angeles, and Washington D.C., we’ve seen cities like Minneapolis, Denver, Philadelphia, Detroit popping up in reports of strong real estate activity. These cities offer an investment premium on a risk-adjusted basis over what can be achieved in the gateway cities. Many cities that have been characterized as secondary markets are attracting companies and employees by adapting to vibrant live, work and play environments.

Q: And the elephant in the room: What effect do you think the U.S. presidential elections are having on U.S. real estate investment?

A: There’s stalling of certain investment and purchase decisions because of the uncertainty around the elections. It’s just consuming many people’s psyches so they’re not interested in going forward—they don’t know what the policies are going to be with the new administration. I would say that is also connected to the trauma caused by the 2008 meltdown that still permeates the minds of a lot of the decision-makers. It makes them hesitant.

© Copyright 2016. The views expressed herein are those of the author(s) and not necessarily the views of FTI Consulting, Inc., its management, its subsidiaries, its affiliates, or its other professionals.
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