The reaction of REIT prices on Tuesday to tumbling Wall Street stocks reveal disquieting links between the two.
This week’s 3.3% plunge in the Dow Jones Industrial Average was a financial event triggered by a stock sell-off in Shanghai rather than by an economic shift, real estate researchers say. Theoretically, real estate fundamentals are driven more by the economy than by volatile financial markets. Yet REIT prices dropped more than 3.2% on Tuesday, highlighting the role of stockholder sentiment in REIT pricing.
“Diversification doesn’t always help you,” comments Clint Myers, a real estate economist at Boston-based Property & Portfolio Research. “China falls, the Dow falls, but then it brought REITs down with it. That’s not how diversification is supposed to work.”
The week’s events appeared to have been triggered by remarks Alan Greenspan made to Chinese investors, in which the former Fed chairman mentioned the possibility of a U.S. recession. Fears of stifled corporate profits due to a U.S. recession resulted in a 9% slide in Shanghai stock prices, sparking sell-offs in markets around the world. Analysts say the Feb. 27 price drop reflects increasing investor aversion to risk, or an expectation of greater returns (and lower prices) to reflect an ’s risk.
“In some ways, the (stock) market can be seen as a barometer of sentiment,” says Jaime Woodwell, senior director of commercial/multifamily research at the Mortgage Bankers Association.
Commercial real estate has traditionally been treated as a less-volatile – and therefore less risky – investment than corporate stocks. That’s due to the intrinsic value of hard assets in addition to income generated by properties, and because profits are driven by real estate fundamentals rather than financial markets.
The recent slide shows that argument only goes so far, at least for REIT prices, which fell nearly in step with the Dow. “The question becomes, is that sentiment carrying over into any fundamentals in the commercial real estate market?” Woodwell says.
On the lending front, borrowers may benefit in the short term, according to PPR’s Myers. That’s because investors fleeing the stock market and buying into the safety of U.S. Treasuries drove up prices – and drove down yields – on the benchmark 10-Year Treasury note from to a two-month low closing rate of 4.5% from 4.63% the previous day.
But will lenders lower mortgage rates? Maybe not, if the greater appreciation of risk premiums today influences them to require a greater spread from Treasuries, according to John Burford, senior vice president and investment portfolio manager at The International Bank of Miami. “They would tend to let that spread widen as an indication of risk.”
Banks are more likely to lessen risk exposure by tightening lending standards rather than raising mortgage rates, says Burford, who makes both residential and commercial real estate loans. “Some may try to take fewer chances, with lower loan-to-value ratios, maybe.”
As long as businesses remain profitable and consumers enjoy high employment levels and salary increases, Burford expects the economic expansion to continue and to drive demand for commercial real estate.
The February market correction is a sign that expansion is nearing an end, however, according to Craig Thomas, senior vice president and director of research and research systems at Boston-based CBRE Torto Wheaton Research.
In recent years, aggressive pricing around the globe of everything from bonds to real estate has largely ignored risk, Thomas says. Eventually that overpricing is bound to correct itself, and will likely end the current economic expansion. “What we saw on Tuesday was the first volley,” he says.
“It’s a symptom of the imbalance we have, and I expect we’ll see more frequent occurrences,” Thomas adds. “At some point, one of these re-pricings will create a cascade effect that will remove liquidity from our economy, and that will likely be recessionary.”