MARKET AND ECONOMIC CONDITIONS
By Adam B. Landau
Permit Capital Advisors, LLC
There is near unanimous consent amongst the investment managers and pundits we trust that markets around the world and across the asset class spectrum, are at best fairly valued and at worst overvalued in a way that looks and feels like 1999 or 2007. However, it is important to remember that valuations, while an important long-term guidepost for market decisions, are historically a poor guidepost for timing those decisions in the short- term. This recognition leaves our efforts focused on idiosyncratic value creation (opportunities that are less correlated, or even negatively correlated, to what is occurring within “the market”), setting appropriate expectations (for ourselves and our clients), and remembering Warren Buffet’s advice about investor psychology. It was in Berkshire Hathaway’s 1986 Chairman’s Letter that he suggested that it is wise to “be greedy only when others are fearful.”
Investors who could be considered fearful today appear to be in a minority, at least based upon the depressed level of the VIX index (a measure of market volatility often referred to as the “fear index”). Although there may be a distinction to draw between investment behavior borne of confidence and that which is borne out of a perceived lack of better options. The latter is a nod to the now-familiar notion that the Federal Reserve’s all-out assault on deflation has driven yields lower, multiples higher, and made pricing signals less relevant than would otherwise be the case. This would suggest that visibility about the Fed’s timeline is as important as any indicator, including valuations, with respect to sea changes in market direction and sentiment.
The PCE (Personal Consumption Expenditure) Index, the Fed’s preferred measuring stick for price stability, ticked up from 1.1% in March, to 1.6% in April, to 1.8% in May, and now sits within sight of the Fed’s long-term target of 2%. At the same time the Unemployment Rate has trended down to 6.2% today (and it would be lower if the Participation Rate hadn’t finally started to move up), although the Fed’s long-term target here seems to be a moving one. At first glance, this would appear to presage an end to both Quantitative Easing (QE) and the Zero Interest Rate Policy (ZIRP). Yet communications from the Fed have made it clear that while QE is on the way out, ZIRP is here to stay for a while. (The one consistent and vocal dissenter on this front has been Philly Fed President Charles Plosser). The focus, for now, is squarely on wage growth, which has been tepid for the duration of this recovery. The future evidence provided by Average Hourly Earnings would appear to now serve as the proverbial “canary in the coal mine”.
Investing against this tenuous backdrop calls for a diligence in rebalancing, with one eye on strategic targets and the other on macroeconomic and monetary forces. The economy is entering its “late-expansion” stage, which means that at some point soon the market should begin to discount the higher future inflation we’re starting to see. This phase of the cycle generally corresponds to outperformance of economically sensitive sectors such as industrials, materials, energy, and real estate.
Today, we are at an unusually attractive mid- cycle point for real estate, where well positioned commercial real estate assets are experiencing levels of demand and occupancy that are shifting pricing power to the landlord, making the economics quite favorable across all property types. At the same time the lasting impact of the last financial/ economic correction has left sufficient scars to delay the normal pace of new commercial real estate supply. The result is strengthening valuations of commercial real estate assets and the potential for private commercial real estate values to move even higher over the next few years. As long as U.S. economic growth remains above 2%, combined with the current level of job growth and favorable demographics, occupancy and rents will push higher across all property segments. Property values, as a result, will also likely move higher even if “cap rates” do not decline.
The recovery cycle has finally begun to lift office occupancy in the U.S. against very limited new supply. This is occurring even with moderate employment growth, shrinking office space demand from traditional financial institutions and a trend towards less space per employee. New drivers of demand are technology/media and energy based users. Retail real estate occupancies are rising into the low 90’s and rents are lifting driven by growth retailers creating “omni-channel” strategies combined with demand to “show the brand” in targeted markets. While the fuss over “online” retail vs real estate continues, it has not stopped rising demand for well-located commercial retail real estate space in higher density markets. Furthermore supply additions in these markets are limited and available retail per capita is actually declining for the first time in decades.
We do not expect overall economic growth in the U.S. to accelerate to a new higher level but the characteristics of the demand drivers should remain in place for several years. Furthermore higher interest rates, at least within 100 basis points from current 10-Year Treasury levels (2.5%), will have very little actual impact on the attractive real estate economics described above. Longer term commercial real estate cycles (post a recovery period) are primarily driven by economic demand forcing occupancy higher while supply of new commercial real estate lags the recovery. This is a very gradual process as real estate economics do not change direction quickly. If this assessment of new commercial real estate development opportunities is correct, it will take several years for new supply to reach levels that impact commercial real estate cash flows and values. This does not imply that supply is not coming as conditions are favorable for a commercial real estate construction cycle to commence.
About Adam Landau
Adam Landau is Chief Executive Officer and Chief Investment Officer of Permit Capital Advisors, LLC. He has 15 years of experience evaluating investment managers, developing asset allocation strategies, and coordinating the process by which the two disciplines are merged. Visit http://www.permitcapital.com to see how Adam and Permit Capital Advisors, LLC can