Real Estate and Globalisation E-Book

Richard Barkham

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 510

Veröffentlichungsjahr: 2012

Beschreibung

2000 to 2010 was a remarkable decade for real estate. It started with the dot.com bubble and ended with the putative recovery from the Great Financial Crisis. The period in-between featured the world's first coordinated real estate boom and slump. This book is based on a series of briefings on the relationship between macro economic events and real estate markets in the era of globalisation that covered the period. Collectively they offer unique insights, new ideas and practical approaches to real estate economics, grounded in the day-to-day realities of investment, development and fund management operations in a leading international property company.

All the briefings are based on research conducted by a sophisticated in-house research team with expertise in macroeconomics, urban economics, financial economics and econometrics, led by a well- known specialist in the field. The topics highlight the relationship between real estate markets and global economic and political events – an area not well covered by academic journals.

A compelling introduction considers the dramatic boom and slump in real estate values that led up to the Great Financial Crisis. The briefings are then presented, grouped into broad themes: macro economics and real estate; GDP, recessions and inflation; REITs; construction; Asia; retail, offices and housing markets; the formation of investment yields. A final chapter considers the medium-term future for real estate in the context of the ongoing financial crisis.

Topics span the key sectors of office, retail and residential real estate in over 40 countries, with a focus on private sector investment, development and management. The perspective is long term, reflecting Grosvenor's unique position in real estate as a privately owned group.

The author provides a commentary on each topic, giving context to the research and the implications for strategy, drawing out two unifying themes: the effect of globalisation; and the importance of macro economics and geo-politics in real estate research.

Together, the briefings offer a penetrating analysis of real estate markets in the era of globalisation and financial crises. The era of crises is far from over, and Real Estate and Globalisation provides invaluable insights for property professionals worldwide – developers, occupiers, investment analysts and planners – on the nature of the processes that create such intense property market volatility. The book is also a unique source of guidance on practical property research for final year undergraduates and postgraduates on property courses, as well in geography, planning, architecture, and construction.

Leseprobe

Table of Contents

Cover

Title page

Copyright page

Foreword

Preface

Acknowledgements

1 Introduction

A remarkable decade for real estate

Based on a flawed global economic model

The real estate research agenda

Background to this book

2 Macro-economics and real estate

Impact of the recession on US property markets – evidence so far (November 2001)

State of global property going into 2004 (January 2004)

Is the global recovery running out of steam? (November 2004)

The outlook for private business investment in 2010 (January 2010)

Are we heading towards global deflation? (December 2001)

Deflationary conditions may be already present in parts of the West (October 2002)

Are buoyant asset markets enough to stimulate recovery? (March 2010)

Has the global economy passed its worst? (July 2001)

How will rising interest rates impact real estate markets? (January 2011)

Is the USA really in recovery? (December 2002)

Investment could lead the recovery – but not yet (July 2003)

UK savings rates have recovered, but the USA still looks out of balance (September 2002)

How to save the world: by not saving (December 2009)

Events to watch – is OPEC about to set off a second oil crisis? (October 2000)

How is this oil shock different from the 1970s? (October 2005)

Global financial markets – remaining challenges to a sustained recovery (August 2010)

The Euro finally arrives – but will that make much of a difference? (January 2002)

Germany (April 2002)

Germany’s economic situation (April 2003)

3 Real estate and recessions

An overheated housing market may cloud the Spanish economic landscape? (November 2006)

When will the US housing market turn? (January 2009)

The sub-prime storm – impact on Europe (October 2007)

A year on: the sub-prime crisis from a Spanish perspective (August 2008)

Global headwinds – US real estate debt (February 2010)

How close are we to a new ‘Great Depression’? (October 2008)

Printing money – will it work? (April 2009)

Are recessions bad for real estate? (February 2008)

4 Inflation and real estate

Does property provide a hedge against inflation? (September 2009)

Linking rents to construction cost inflation – the French case (March 2008)

Oil prices, inflation and real estate (July 2008)

Is inflation building up in the world economy? (June 2010)

Can oil prices cause a global inflation problem? (June 2004)

Are food prices driving inflation up? (December 2007)

Real wages and real estate in the UK (February 2011)

5 Retailing and retail property

Splitting retail property into food and non-food can increase portfolio performance (November 2003)

A prosperous future for UK shopping places? (December 2006)

Examining European retail rents (January 2006)

Perspective on international retail (October 2001)

Consumer confidence and consumer spending (June 2003)

The outlook for UK retail (August 2009)

USA retail outlook (August 2004)

What will an end to the run-up in house prices mean for consumer spending? (April 2005)

Housing prices and consumer spending

What about the longer-run relationship between housing and consumer spending?

Retail fundamentals (January 2003)

US retailing in recession (May 2009)

Luxury retailing in Europe (June 2007)

State of health in the retail market in continental Europe (October 2009)

6 Property companies and REITs

Small investors should wait for the REIT moment to invest in property securities! (January 2007)

Listed real estate in a ‘perfect storm’ – the case of Spain (November 2008)

Beta and the cost of equity capital to the UK property sector (May 2008)

7 Real estate and construction

What factors determine construction costs? (March 2006)

Is there a global construction boom? (April 2007)

UK construction costs and the recession (March 2006)

8 Asia

China/WTO (January 2002)

Chinese currency reform (December 2004)

What’s the outlook for the Chinese economy? (June 2009)

Recovery has started

Premature to pronounce sustained upturn

Housing market running ahead of the economy

Will China’s problematic inflation subside? (June 2008)

Is real estate in China heading for a hard landing? (March 2011)

Runaway inflation concerns are exaggerated

A real estate market collapse is not imminent

A hard landing in the long term?

What’s happening to Japan? (March 2004)

Japan capital values (September 2004)

Bank of Japan ends quantitative easing – the impact on property will be neutral (April 2006)

The growing significance of Asia-Pacific real estate (November 2007)

9 Real estate returns

Do investors care about the standard deviation of property investment returns? (July 2009)

Returns and capitalisation rates in US real estate (August 2006)

The economics of global property returns (May 2007)

Does gearing work? (October 2010)

10 Residential real estate

The potential for investment in European residential property (September 2007)

Investment opportunities in US housing (July 2010)

Trends in owner-occupied residential prices are not always a guide to value trends in the investment sector (August 2003)

How important is confidence in the Asian luxury residential market? (October 2002)

Luxury residential – the tale of three cities (September 2005)

What drives Prime Central London residential prices? (September 2006)

US home prices looking more exposed (August 2005)

Why do commentators continue to talk of a UK housing crash that never seems to come? (June 2002)

Australian residential outlook – as safe as houses? (December 2010)

Australian residential prices – city trends drive performance (October 2006)

How does the top-end outperform?

11 Yields

How far can yields move out? (January 2008)

Bond yields, real estate markets and globalisation (May 2010)

Cross-country determinants of investment yields (March 2005)

How does the risk of rising interest rates affect property yields and expectations for property performance? (February 2006)

Incorporating interest rate expectations into investment forecasts

Can movements in corporate bond yields tell us anything about movements in property yields? (December 2005)

Capital flows to emerging markets (May 2006)

Real estate investment yields – bouncing up or down? (January 2005)

Signs of change in the investment market? (January 2003)

Lease flexibility and income security in international property markets (February 2004)

Impact of tighter regulations on bank lending (November 2009)

Appendix

Modelling global real estate yields (November 2008)

United States

Australia

France offices

Spain offices

Ireland

United Kingdom

Japan

Hong Kong

Concluding comments

12 Global office markets

Just how rewarding is office sector investment? (February 2003)

Supply-constrained office markets do deliver stronger rental growth – but not always (January 2004)

Europe’s largest office markets are set to lead the recovery (April 2004)

Supply risk in international office markets (June 2005)

Office markets and the global economy (April 2008)

Can local office markets buck international market trends? (July 2003)

Euro zone convergence – economic myth and property reality (June 2006)

Convergence continued – the US case (July 2006)

Does income inequality affect office rents? (November 2005)

13 Looking forward

The case for increased pension fund allocation to real estate (September 2010)

Index

This edition first published 2012

© 2012 by John Wiley & Sons, Ltd

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Library of Congress Cataloging-in-Publication Data

 Real estate and globalisation / by Richard Barkham.

p. cm.

 Includes bibliographical references and index.

 ISBN 978-0-470-65597-9 (pbk. : alk. paper) 1. Real estate business. I. Barkham, Richard, 1961–

 HD1375.R3723 2012

 333.3–dc23

2011045310

ISBN 978-1-118-35166-6 (epub)

ISBN 978-1-118-35165-9 (mobi)

A catalogue record for this book is available from the British Library.

This document and the information herein have been produced internally by the Research Department of Grosvenor Group Limited (“Grosvenor”) solely as a compendium of the monthly outlook reports. The monthly outlook reports are Grosvenor’s research perspective on the global real estate markets. This document is intended as a research resource for general informative purposes only.

The information has been compiled from sources believed to be reliable however its accuracy and completeness are not guaranteed. Readers are advised and informed that none of the information contained in this book amounts to investment, legal or other advice. Certain statements contained herein regarding the markets are of a forward-looking nature and are based on Grosvenor’s research team’s assumptions about future developments and future events, and therefore involve certain risks and uncertainties. Actual results may vary materially from those targeted, expected or projected due to several factors, and there can be no assurance that the actual results or developments anticipated will be realized or, even if substantially realized, that they will have the expected consequences. Grosvenor does not assume any obligation to release any updates or revisions to any forward-looking statement and the delivery of this document at any time shall not create any implication that there has been no adverse change in the information set out in this document or in the affairs of the Company Group since the date of this document.

The opinions expressed are those of the Research Department of Grosvenor at this date and are subject to change without notice. Reliance should not be placed on the information or opinions set out herein for any purpose and Grosvenor will not accept any liability in contract, tort or otherwise arising from such use or from the contents of this document.

Foreword

There is something unusual – perhaps unhealthy – about an industry in which a 25-year-old with almost no prior experience can make a fortune overnight. The fact is that you can get into property with little more than a telephone and a total disrespect for risk. The industry abounds with stories of a few thousands turned into millions. Property investing attracts, because it is very straightforward and visual. Once we have bought and sold our own home, we have experienced the essential mechanics of property investing. This is reflected around boardroom tables as well, where there is only rarely a specialist but, apparently, many experts.

In large property companies, there should be experts of course. But even here there has been a traditional assumption that it is ‘unconscious genius’ that will bring greatest success, not dedicated research. I am a great believer in instinct, but when it comes to managing a 300-year old business, something more is needed. So, when we reorganised the property business of the Grosvenor Estate in 2000, we did something which was probably unique at the time for a large property company. We established a dedicated research group around the world. As an internationally diversified investor and developer, we believed strongly in the notion that real local decision-making was essential and that a model of managing from London (as various peers had done) was flawed. The primary role of the centre would be to decide how much capital should be invested in each local business.

The research teams, coordinated but answerable to their local management, would provide a common ‘language’, as well as the medium through which valuable knowledge could be refined and moved around our business. Part of the output of the team would be a monthly commentary for all the Boards and staff on a single topic of relevance and interest. It is expensive to run such a team and so its establishment was in itself a real example of managing for the long term; something which many profess, but few are really prepared to pursue.

After some years it became obvious that collecting the short papers together would be valuable, as both diaries and refreshers on topics that keep coming back. I am delighted that my wish to do this has been realised in a much more sophisticated way than I ever imagined.

I particularly want to commend Richard Barkham, Grosvenor Group’s Research Director, and Darren Rawcliffe, his predecessor, for their work in establishing the team and the intellectual rigour they added to our strategy. While never allowing them to dictate, they and their colleagues have informed every aspect of strategy since 2000. Richard’s expert editing and introductory commentaries have provided a fascinating ‘look back–look forward’ feel to the collection, which I hope will be a worthwhile addition to the rather thin collection of books about the complexity of managing an international property company at the beginning of the 21st century.

Jeremy Newsum

Non-executive Director

Grosvenor

Preface

Grosvenor is an international property company whose roots, in the areas of London known as Mayfair and Belgravia, go back more than three hundred years. In 2000, Grosvenor took the step of creating a research team to support its growing fund management business and international diversification strategy. Each month for the last 11 years Grosvenor’s research team, which now consists of 12 real estate economists, has produced an article on an aspect of real estate economics which seemed topical at the time. The series is called the ‘Global Economic Outlook’ and is distributed internally and to contacts and clients of the company. Sometimes the articles are based on recent macroeconomic developments and the implications for real estate markets and sometimes they attempt longer-term projections or cross-country comparisons. Although the topics covered have varied a great deal, the aim has always been to undertake original analysis using the tools and techniques of economics. Individual articles are produced by Grosvenor’s research economists in the UK, North America, Asia and Europe and must be no more than 800 words long. This word limit is stipulated by the board of Grosvenor which requires its economics to be pithy. There has been no particular attempt over the years to develop a long term theme or maintain a particular editorial line. First and foremost the articles are constructed to enable Grosvenor to deploy its own and its clients’ capital to best effect, in a very turbulent world.

In reviewing the series it became clear that these articles, though never specifically addressing this issue, told a very interesting story about the impact of globalisation on the volatility and performance of real estate markets. Over the last 10 years national economies have become ever more intertwined. Emerging markets have taken a greater share of production, providing OECD consumers with ever-cheaper manufactured goods delivered through sophisticated supply chains. Capital has flowed from high-savings economies to low-savings ones, not only though public capital markets but also, less obviously, via banks’ cross-border investments in the bonds and commercial paper of other banks. All the while, developments in communications technology, including the internet, have increased the volume of data delivered to consumers and businesses so that events in, say, Japan, quickly impact on sentiment and economic activity in the UK. These developments have brought many benefits, but they have also created huge economic distortions. Some countries have over-consumed and built up debt; others have saved too much and built up excess foreign currency reserves. The lack of an appropriate global fiscal and monetary policy framework has meant that the economic power of globalisation has been misdirected. One consequence of this has been very high levels of volatility in asset markets, including the real estate sector. The central purpose of this book is to use the articles to sketch out the link between globalisation, by definition a profound international process, and the dynamics of real estate markets, which until very recently have been dominated by purely local factors.

Although one of the by-products of globalisation is that economic and market data is increasing exponentially, it is still necessary in the real estate sector to spend time and effort ensuring a degree of consistency across markets. Only in this way can valid international comparisons be made for the purpose of asset allocation. Nevertheless, all research requires judgments to be made and nowhere is this truer than in the field of international real estate research. The second purpose of this book is to present Grosvenor’s approach to the analysis of international real estate markets and the variety of methods we have used to analyse data and arrive at conclusions. Our hope is that students and possibly others will gain some insights into the way in which research can blend with practice to help shape the strategic agenda of a major company. Many of the research themes in the book need to be followed up, as they seem to us to have social as well as commercial relevance. Grosvenor’s research team will continue to explore the impact of global economic change on real estate markets; we hope that others will be inspired to do so as well.

Richard Barkham

Acknowledgements

The monthly Global Outlook was devised by Darren Rawcliffe and edited by him between 2000 and 2005. Richard Barkham has edited the series since 2005. Richard Barkham designed this book and is responsible for the introductory and concluding chapters as well as the individual chapter commentaries. Ruth Hollies managed the global yield project, the results of which are included as an appendix to Chapter 11. Current or former members of the Grosvenor research team who have contributed by producing articles or analysis are as follows:

Ian Anderson

Dr Richard Barkham

James Brown

Dr Josep Camacho-Cabiscol

Manish Enaker

Richard B. Gold

Maurizio Grilli

Dr Beatrice Guedj

Ruth Hollies

David Inskip

Chi Lo

Fiona MacAonghusa

Graham Parry

Cynthia Parpa

Shabab Qadar

Darren Rawcliffe

David Roberts

Harry Tan

David Wasserberg

1

Introduction

A Remarkable Decade for Real Estate

The decade from 2000 to 2010 was the most exciting, remarkable and ultimately disastrous period for real estate since the end of the Second World War. Those dramatic ten years witnessed the world’s first coordinated real estate boom and slump. Real estate cycles are a common feature of free market economic development and, from time to time, they badly destabilise individual economies. In the years before 2007, real estate values were driven to peak levels across the greater part of the developed world. When prices collapsed in 2008, by up to 60% in some countries, the global financial system was almost destroyed and a new Great Depression ushered in. At the time of writing (mid-2011), the aftershocks of the great financial crisis (GFC) linger on, in the sovereign debt crisis of Southern Europe and in the moribund housing market of the USA. Unemployment in the developed world, the social cost of the crisis, remains very high.

For real estate, the 2000s started rather unpromisingly amidst the global recession created by the bursting of the ‘dot-com’ bubble. Between 1996 and the end of 1999, on the back of easy money, buoyant global growth and widespread optimism about the potential of the Internet, global stock markets rose by 24%. Between 2000 and 2003, all of these gains were reversed, as world markets fell by 30%. The swings in value were much greater in the stock markets of the USA and the UK. Investment fell and unemployment rose. Contraction in the corporate sector led to a fall in demand for business and commercial space and a steep drop in rents. The real estate recession of the early 2000s was particularly severe in the office sector, because demand for offices depends directly on the state of the financial markets.

It is worth reflecting on the ‘wreckage’ of the dot-com slump, because it is here that the real estate story of the 2000s begins. Since the early 1990s, OECD central banks have been haunted by the spectre of Japan. Between 1950 and 1989, Japan was one of the word’s fastest-growing and most dynamic economies. Towards the end of its long expansion, its stock market and land market dramatically boomed and slumped. Since then, Japan has been unable to shrug off slow growth, deflation and a chronic inability to create jobs. The reasons for Japan’s 20-year deflation are complex, but most agree that monetary policy was too tight in the post-bubble period. This is a mistake that OECD central banks do not wish to repeat. So, in the wake of the stock market crash of 2000, interest rates were cut aggressively to support asset values, boost confidence and revive business and consumer spending. Figure 1.1 shows OECD real interest rates over the period: it is the key to understanding the events of the 2000s and the GFC.

Figure 1.1: OECD real interest rates

Source: IHS Global Insight

It is often said that using interest rates to stimulate an economy is like dragging a brick with an elastic band: nothing happens for a while and then the brick jumps up and hits you on the back of the head. This is how it played out in the real estate sector. The period 2001 to 2003 saw depression in most asset markets; confidence was weak as the global economy worked its way through the aftermath of the tech-crash. Suddenly, in 2003 a ‘wall of money’ hit the real estate sector. Investors, nervous of the stock market, were not prepared to tolerate the low returns on cash and bonds that resulted from super-loose monetary policy. The ‘search for yield’ was on and real estate was suddenly the most favoured asset class. The long, globally coordinated boom in real estate values had begun. Figure 1.2 shows a global composite yield for the retail sector and the office sector. The period from 2003 to 2008 saw a rapid and continuous appreciation of prices driven entirely by investment demand.

Figure 1.2: Retail and office global composite yields

Source: CBRE

The first wave of investment was primarily driven by ‘equity’ investors; those for whom easy access to bank finance was not a key issue. These included pension funds and insurance companies, high net worth individuals, private equity funds and, increasingly, newly created sovereign wealth funds. Even small investors, through the medium of open-ended funds or other ‘retail’ vehicles, were clamorous for real estate. REITs (Real Estate Investment Trusts) were prominent investors; the ten years to 2007 had seen REITs or REIT-type vehicles approved in over eight jurisdictions (figure 1.3). The period also saw the very rapid growth in unlisted real estate funds (figure 1.4). These tax transparent vehicles provided a convenient means for professional investors to deploy capital in diversified pools of real estate assets run by professional real estate managers.

Figure 1.3: Growth of REITs

Figure 1.4: Growth in non-listed real estate funds

Source: Property Fund Research

‘Behind the scenes’, it was low interest rates that were fuelling the boom. Low interest rates (or expansionary monetary policy) have a ‘double impact’ on the attractiveness of real estate as an investment. First, they lower the cost of holding the asset. Second, by boosting the cash flow of occupiers, they improve the security of real estate operating income. At the time, the link between booming real estate values and super-loose monetary policy was not widely appreciated. Indeed, many market participants preferred to think about the ‘golden age of real estate’. Real estate, with its long duration and stable cash flows and increasingly good data provision, was the institutional asset of choice.

By 2005, the initial impetus to real estate values from ‘equity’ investors had been replaced by debt-driven buyers; namely, buyers with very high levels of leverage. Such ‘players’ are a feature of any rising real estate market, often originating in markets with low or negative real interest rates (where interest rates are lower than domestic inflation). In the mid-2000s, debt-driven investors from Ireland, Iceland, Spain, the USA and Israel flooded into the marketplace. Figure 1.5 shows money flows into real estate over the period, by type and destination.

Figure 1.5: (a) Capital flows into real estate by type; (b) Capital flows into real estate by origin

Source: DTZ

Banks generally find real estate an attractive asset, but particularly when interest rates are low and economic growth is strong. Unlike businesses, real estate assets are relatively easy to appraise and assess for creditworthiness. Moreover, the market is large, and at times of rising values it can create additional lending opportunities very quickly. For instance, we estimate that the total value of real estate in the US is $7.7trn, so a 10% increase in values creates $770bn of additional ‘lending opportunities’. No other sector gives banks the ability to increase their loan books as quickly as real estate. Compounding this, as we now appreciate, banks in the OECD can operate on the assumption that that they will not have to bear the full consequences of risky lending decisions. In any case, in the mid-2000s, it became quite clear that the major lending banks had replaced carefully considered lending with market share as their main objective function. Real estate was the sector of choice.

Two further factors facilitated the flow of debt into the real estate sector in the mid-2000s. One factor related to globalisation was the long-term growth in the usage by banks, in all regions, of the money markets for funding. Since the 1960s, customer deposits have fallen as a share of banks’ liabilities and certificates of deposit, repurchase agreements and commercial paper have increased. As long as the money markets were open, the banks could expand lending way beyond the level that would be supported by their own domestic deposit base. During the 2000s, at least until 2007, it was very easy for banks in countries such as Spain, Portugal and the UK to tap the money markets in order to expand lending to real estate. Moreover, on the supply side, ‘excess savings’ in other parts of Europe and Asia saw the money markets awash with liquidity. This process, which might be called the globalisation of banking, is one of the key mechanisms by which real estate markets which are local in character can be swamped by international money flows. In the lead-up to 2007, banks in high savings areas invested in banks in low savings areas, allowing the latter aggressively to expand lending (Figure 1.6).

Figure 1.6: Net credit position of Greece, Ireland, Portugal and Spain banks with banks in the rest of the world

Source: BIS

Alongside the globalisation of banking was the growth of loan securitisation. Securitisation is the process by which pools of loans, for instance real estate mortgages, are ‘bundled’ together and the rights to receive the cash flows from these loans are sold to investors. The bank that sells this collection of loans receives cash (asset), which in due course it can recycle into additional lending and it deletes the loans (assets) from its balance sheet. In principle, there is nothing wrong with this; it has been a feature of the US mortgage industry for many years. Non-bank investors get access to stable investments with a good cash yield and banks get cash to help them engage in their primary task to provide loans to those that need them. However, there are two potential flaws in securitisation. First, in the circumstances of lax supervision and extreme monetary stimulation that characterised the early and the mid-2000s, it created an incentive for banks to originate loans for the sake of creating investment products, rather than supporting commercially sensible business transactions. Second, it facilitates the ‘unseen’ build-up in leverage within a market – in this case the real estate market – because the loans are ‘off-balance sheet’. Loan securitisation was a major part of the ‘shadow banking sector’, which ballooned in the five years prior to the GFC. Figure 1.7 shows the growth of securitised real estate.

Figure 1.7: Growth of securitised real estate debt (CMBS)

Source: CRE Financial Council

The worst excesses in real estate loan securitisation took place in the US housing market in the six years to 2007. Here, mortgage lending to the general public became aggressive to the point of being fraudulent.1 To create loans that could be securitised and sold to investors as quickly as possible, originators devised mortgage products that eliminated the need for lenders and borrowers to consider in any way, shape or form the ability of the latter to repay their debts. For instance, ‘the stated income loan’ or, as it is more notoriously known, ‘the liar loan’ allowed mortgage finance to be advanced to house buyers in extremely marginal occupations.2 Not surprisingly, US house prices, which had in any case been rising strongly since the mid-1990s due to strong job growth, surged. At the same time, the capital markets, concerned as they were to secure ‘yielding investments’, received an enhanced flow of just the sort of product they were after: mortgage-backed securities. Figure 1.8 shows the rise and fall of US house prices.

Figure 1.8: Long term growth of US house prices

Source: Global Property Guide

The economic factors that drive the price of houses are: the cost of mortgages (interest rates); the rate of job creation (consumer incomes); expectations of future price rises (investment motivation); and the rate of construction of new premises (supply). In late 2006 rising interest rates, falling job growth and surging new construction hit the US housing market and sent prices, albeit slowly at first, into decline for the first time in the postwar period. The impact of the fall in US house prices on global capital markets took some time to emerge, but it was profound when it did. As it turned out, numerous financial institutions, including some of the world’s best-known banks, had invested in mortgage-backed securities in general and US residential mortgage-backed securities in particular. The scale of this investment and the fact that the banks themselves had historically high levels of leverage meant that the global financial system was under serious threat. In addition, certain key insurance companies were in jeopardy, because they had insured mortgage-backed products. Capital had poured into the US housing sector and driven it to the point of implosion; globalisation ensured the rapid and widespread transmission of the shockwaves.

From a narrow real estate perspective, the interesting fact is that the boom in US house prices was far from the most extreme in the OECD. The long and relatively consistent run of GDP growth (and job creation) that took place in much of the OECD in the period after 1992 provided the housing markets of the developed world with a significant growth impetus. The decline in inflation and consequent fall in long-term interest rates over the period made mortgages more affordable in many countries. In some areas, such as the USA, boosting the rate of home ownership was a key government objective, which was manifested in the tax-deductibility of mortgage interest payments. For all of these reasons, housing markets in most of the OECD ‘did well’ in the 1990s (see figure 1.9). In fact, by the end of that decade house-price-to-income ratios were at an all-time high.

Figure 1.9: Long term growth of OECD house prices

Source: BIS, ABS,National sources, Global Property Guide

The relatively mild recession that ensued in the wake of the tech-crash of 2001 had two effects on global housing markets. Initially, because of the rise in unemployment and the fall in confidence, there was a period of stagnation. By 2003 however, interest rate cuts had begun to revive the market and, shortly afterwards, growth resumed. Britain, Spain, Ireland and Australia experienced a particularly strong period of house-price appreciation, which led to a fall in underwriting standards and a generalised reduction in risk premiums. In 2008, as interest rates peaked, these and other housing markets in the OECD came to a juddering halt. At the time of writing, Spain and Ireland are still struggling to recapitalise commercial banks that are having, as a result, to write down huge quantities of real estate loans.

In September 2008, Lehman Brothers, an important US investment bank, filed for Chapter 11 bankruptcy protection. This event neither initiated the GFC nor signalled the bottom of the market. However, in the demise of Lehman Brothers due to high gearing and over-exposure to the US housing market, the world began to see the full extent of the banking and real estate crisis that it was facing. Two remarkably destructive negative feedback loops, both driven by sentiment, were initiated. The first was in the manufacturing sector. Companies, fearing a collapse in demand, immediately cut stocks and fixed capital investment, which produced a steep fall in global output. Companies and consumers, fearing a generalised collapse in the banking sector, withdrew their savings, further undermining the banking system. Economic confidence collapsed, as did stock and real estate values (Figure 1.10). By the end of 2008 it seemed as if the developed world was on the verge of a 1930s-style Great Depression.

Figure 1.10: Collapse in real estate values

Source: IPD

As momentous and fearful as the events of 2007 and 2008 were, the more remarkable event was the scale and rapidity of the bounce-back. By the end of March 2009, it was becoming clear that a disaster had been averted and that some sort of recovery was under way. The situation was stabilised by the bank rescue packages put in place in 2008. The US government initially flirted with the idea that companies – even banks – should bear the economic consequences of their own actions, but in the end a full-scale bail-out was offered to the sector, as it was in the case of the UK and the Euro zone. In order to revive growth OECD governments collectively mounted the biggest fiscal stimulus in history. In order to revive asset markets and prevent deflation taking hold, central banks cut interest rates to zero and initiated the policy, developed by Japan in its long battle with deflation, of quantitative easing. The policy worked: in the first quarter of 2009 asset markets, including real estate, staged a surprising rebound. Shortly afterwards, economic growth resumed and by mid-2010 inflation was trending back to its target level in the OECD.

Based on a Flawed Global Economic Model

Real estate markets are always driven by economic growth. If the period 2000 to 2010 was remarkable, it was because the underlying global economic situation was, too. The great coordinated boom in real estate values, which peaked in 2007, reflected a global economy which was growing more strongly than ever but was increasingly prone to instability in asset prices. The GFC, which was due to excessive real estate lending, was the direct linear descendant of the dot-com boom and slump and the Asian currency crisis in 1998, which preceded it. These highly unstable economic conditions are still in play today and will substantively impact the real-estate research agenda for the next 10 years.

One of the dominant themes of the 2000s was the robust and increasingly self-sustaining growth of Brazil, Russia, India and China (collectively known as the BRICs). When demand in the OECD collapsed in the wake of the GFC, the BRICs quickly adjusted their economic policy settings and continued to grow. Without the BRICs’ contribution to global demand, the recession of 2008 would have been much worse than it turned out to be. Figure 1.11 shows the growing contribution of the BRICs to global demand.

Figure 1.11: Real GDP growth

Source: IHS Global Insight

In seeking to understand the instability of OECD asset markets over the last 10 years and the next 10, we should focus on one BRIC in particular: China. China’s free market reforms date back to the early 1990s, but in 2001 it was admitted to the World Trade Organisation, giving it greater access to world markets. Cheap and abundant labour has attracted investment by multinational manufacturing companies from the OECD, particularly America and Japan.3 China’s competitive advantage in world markets is assisted by a degree of currency manipulation on the part of the Chinese government. Although China’s trading partners – for instance the USA – make a fuss about this, it suits the interests of their consumers to have access to cheap manufactured products and the interests of their politicians to have downward pressure on inflation.

In order to hold the value of its currency down, China provides an unlimited quantity of RMB to world markets and, as a result, accumulates foreign currency reserves (figure 1.12). The dollars that China accumulates in vast quantities are used to buy US Treasury stocks. In small and balanced measures, these international capital flows are not problematic. However, the scale of Chinese investment in US bonds over the last 10 years has been sufficient to substantially reduce the cost of capital to US consumers and US businesses. The rise of China is directly linked to the build-up of debt in the US economy and the emergence of a large, persistent trade deficit. China, by contrast, runs a large current account surplus.

Figure 1.12: Build up of Chinese foreign currency

Source: IHS Global Insight

China is not the only Asian nation that supplies funds to the USA and the rest of the OECD. The Japanese economy is also characterised by export dependence and weak domestic demand. Japan, like China, has a high savings rate due to the lack of a universal social welfare and pension system. Globalisation allows Japanese savings to flow into OECD asset markets, helping to maintain the value of currencies that should be weaker and depress the overall cost of capital within the OECD, particularly in the United States.

In some ways, the flow of Asian savings into the USA is a very rational response to the risk-adjusted returns on offer. Within the OECD, the USA has the highest growth rate of the mature western economies, because of the rapidity with which it adopts new technology and its willingness to accept high rates of immigration. Moreover, US economic and military dominance means that the dollar has unchallenged status as the world’s reserve currency. US bonds are regarded as the safest interest-bearing securities in the world, even in times of substantial economic turbulence in the US financial system. Low interest rates have been a mixed blessing: they have aided innovation and growth, but have also allowed a huge build-up in consumer and government debt.

The rise of China has had a destabilising effect on the economies of the West which is even more subtle. The years between 1992 and 2007 were ones of unparalleled economic success. This success was assumed to be due to the macro-economic policy mix that emerged from the Thatcher/Reagan reforms of the 1980s. The key elements of this were: (1) the successful control of inflation with short-term interest rates; (2) state provision broadly limited to public goods; (3) flexible labour markets because of reduced union power; and (4) a pragmatic approach to public finances within the constraints of a maximum debt-to-GDP ratio. The period became know as the ‘great moderation’, because of the decline in the rate of inflation throughout the OECD, combined with steady GDP growth4 and employment creation. Figure 1.13 shows OECD inflation over the last two decades. The importance of this fall in inflation cannot be overstated. Not only did it lead to a long period of falling interest rates, leading to a long boom in government bonds, but it gave policy makers a sense that they were fully in control of economic events. Real estate, being for the most part a bond type investment also experienced a long period of stable high returns. The problem was that the decline of inflation was not only due to macro-policy success but also to the flow of cheap manufactured goods from China.

Figure 1.13: OECD inflation

Source: IHS Global Insight

The European response to the economic success of North America and Asia was to consolidate and, to a certain extent, protect the European economic region by the creation of a single currency. The creation of a single currency, it was argued, would allow the single market to allocate resources more efficiently and, in particular, to allow the development of large enterprises, which could compete with American multinationals in using cheap Asian labour.

As it has turned out, the creation of the Euro zone has had a devastating impact on many of the countries that adopted the single currency. The interest rate that was suitable for the northern European countries, such as Germany, with low rates of inflation and relatively sound public finances, was simply too low for those on the periphery: Ireland, Spain, Portugal and Greece. Falling interest rates precipitated a long boom in real estate prices, which stimulated growth in the volatile construction sector and, of course, the build-up of debt. Gains in competitiveness, which were the original aim of the single currency, have not materialised. In fact, it has been the banking sector that has made most use of the opportunities created by the single currency to consolidate and internationalise. Unfortunately, European banks used their increased access to world money markets to lend into an unsustainable real estate boom.

The crisis in the southern European economies arising from excessive real estate and consumer debt is compounded by a profound fiscal crisis. The governments of the Peripheral-4, with the possible exception of Spain, have fiscal deficits that are so large that they threaten the ability of these countries to borrow in the international capital markets. This situation is only partly the result of the structural flaws within the Euro zone, namely: (1) no mechanism or will to impose fiscal discipline on members of the single currency; (2) implicit guarantee of bail-out, leading to moral hazard, because of a history of fiscal transfers between core and peripheral countries; and (3) over-reliance on real estate markets to drive tax revenues. Something more fundamental is at work: governments, like banks and consumers, have over the last 10 years been seduced by the ready availability of cheap capital. Instead of developing policies to counter the economic challenge of Asia, governments have preferred to maintain the living standards of their electorates by borrowing from it.

In summary, there are three strands to the argument that the ‘architecture’ of the global economy is fundamentally flawed. First, currency manipulation by the Chinese is seeing the OECD rapidly lose its share of world manufacturing markets. Second, the combination of rapid economic growth in Asia, particularly China, combined with high savings rates in the region, is flooding the global economy with cheap capital, depressing long-term interest rates in the OECD5. Third, the era of cheap capital, as it has been described, has encouraged the build-up of personal, corporate and government debt in the OECD, making this region highly vulnerable to asset price movements in response to the interest rate cycle. So, when the OECD economy weakens, as in 1998, 2001 and 2007, in response to a collapse in asset prices, the first choice of policy markers is to cut interest rates to reflate asset markets. Low levels of inflation, in part due to the rapid expansion of production in Asia, make, in the short and medium term at least, constant monetary stimulation a viable, if short-sighted strategy. These three strands can be summarised as: high growth, excess savings and low interest rates. When combined with weak regulation of the highly dynamic and rapidly globalising banking sector, then it is quite obvious what caused the Great Financial Crisis. The problem is that, apart from some heavy-handed reform of the global banking sector, since 2007 none of these conditions have changed. OECD policy-makers are relying on low interest rates to restart economic growth and, as night follows day, are creating the conditions for the next boom and slump in the global economy.

The Real Estate research agenda

The purpose of this book is to review a remarkable decade in the history of real estate. If there is a conclusion or a ‘message’, it is that real estate research needs to be more aware of the big issues in the global economy, such as the ‘rise of China’ and the impact in the West of the Asian ‘savings glut’. Perhaps the message is even more radical; real estate research is only likely to produce accurate forecasts when it is fully cognisant of the influence of geopolitics on asset market performance. As globalisation proceeds, real estate outcomes at the city or even neighbourhood level are ever more influenced by politics and economics on the other side of the world. Real estate research that does not imaginatively and creatively deal with these themes runs the risk of being irrelevant.

Academic real estate research, although it provides many carefully analysed case studies and useful theoretical insights, has seemed to be pursuing an ever narrower micro-economic and finance-driven agenda in recent years. So, whilst it is able to provide us with a better appreciation of, for instance, the complex times series processes that describe the evolution of real estate prices; the relationship between real estate traded in the public and private markets; the impact of mature trees on nearby house prices; it was not able to forecast the over-valuation of real estate markets that created the Great Financial Crisis. Nor has there been a great deal of useful retrospective analysis.

So one of the key lessons for real estate research from the events of the last 10 years is that it needs to be far more intelligently informed about the key underlying drivers of the global economy. This is not merely a matter of taking macro-economic forecasts and plugging them into rental models. There may well be a fairly robust statistical relationship between retail sales and retail rental value growth. If, however, retail sales are being driven by ‘super-loose monetary policy’ in an era of cheap capital, then the broader ‘forces acting’ need to be understood. Real estate outcomes are substantially impacted by savings rates, money supply growth, the output gap, labour markets’ flexibility, taxation and fiscal policy. These macro-economic concepts need to be fully understood by real estate researchers and applied to real estate market data.

Such a research agenda is not easy: the pace of globalisation is rendering many traditional macro-economic relationships unclear, or, at least, capable of misinterpretation. For instance, in the period leading up to the GFC it was common to hear talk of the ‘great moderation’. Some politicians even referred to having overcome the economic cycle. After the fact, it is easier to see that inflation was partly held in check by widespread migration (keeping wages down); and the penetration of OECD markets by goods manufactured in low-cost China. Meanwhile, surplus savings in Asia were recycled, via the bond and money markets, into a vast build-up of debt: corporate, government and consumer. Many of these trends were evident prior to the crisis, as many of the articles in this book show; but they were never quite organised into a coherent critical analysis. In any case, these trends will continue to have the most powerful effect on real estate markets. Globalisation is rapidly altering the basics of the world we live in and it needs to be fully part of the real estate research agenda.

A more controversial point, perhaps, is that real estate research needs to be informed by, and interested in, geopolitics. Although it never features in textbooks, macro-economic outcomes are profoundly affected by geopolitical developments. For instance, any hint of waning US military power or its precursor, waning economic power, will affect the value of the dollar, the equilibrium level of US interest rates and, therefore, US real estate prices. The fall of communism, including its abandonment by China, is another example. As it was seen at the time, the chief benefit was lower defence spending and greater resources for social purposes. The more important effect by far was the incorporation into the global trading system of nearly 1.5bn additional workers, allowing a long period of low inflation growth and asset price inflation. A final example is the formation of the Euro zone. Despite the rhetoric about economic efficiency, there is no doubt that ancient concerns about the balance of power in Europe were at the heart of that project. One interest rate for all Euro zone countries has had profound macro-economic and real estate consequences. Geopolitics tends to render economic models irrelevant, so it is a legitimate part of the broader real estate research agenda.

Background to This Book

Over the last 10 years, Grosvenor Research has produced an article a month on some aspect of real estate economics. Although the topics covered and the research methods deployed have been very varied, the aim of the series has always been to assess the ‘forces acting’ on global real estate markets, whether local, national or geopolitical. The articles, almost always written in a rush, are on topics that appeared at the time to be of interest to Grosvenor, its partners and investors. Quite often, we hit on some of the decade’s most important issues, but did not fully predict the full implications of these. Collectively the articles describe and analyse the ongoing impact of globalisation on real estate markets. Each chapter contains an introduction which sets the individual articles in a broader context. The articles appear in the order they are referred to in the text.

Notes

1The Big Short: Inside the Doomsday Machine, Michael Lewis, WW Norton & Co., 2010.

2 When a ‘stated income loan’ is advanced, the lender takes the borrower’s declared income ‘on trust’ and makes no attempt to verify it by recourse to pay slips (stubs), income tax returns, company records, utility bills or any other source.

3 Approximately 30% of Chinese exports are transfers within American multinationals.

4 More technically, the period saw a fall in the standard deviation of quarterly GDP growth rates.

5 In due course, the growth of consumption in China will provide a powerful stimulus to the global economy that will offset the current negative trade shock. However, the full benefits of Chinese consumer spending growth will not be felt until its currency rises and broad social welfare provision reduces the impetus to save.

2

Macro-economics and real estate

A central theme of Grosvenor Research over the last 11 years is that real estate markets – specifically, rental growth and yield fluctuations – are only properly understood in a macro-economic context. Real estate research and advice is only as good as the appreciation of the macro-economic conditions of the time. Of course, we have also recognised the impact of rental and construction cycles, capital market ‘bubbles’, herd behaviour and, at the meta and micro levels, the impact of urban growth and change; but, ultimately, these are all driven by growth in GDP. This said, given the woeful state of macroeconomic forecasting technology and macro-economic theory, for that matter, it is not sufficient to rely on forecasts of the main macro-economic variables produced by governments, central banks, commercial forecasting houses and ‘the consensus’. Consensus thinking is lazy thinking. A deep appreciation of the uses and limitations of macro-economic theory is required, alongside constant awareness of new economic data.

‘Text-book’ economics typically links real estate outcomes to GDP growth, via ‘derived demand’. Real estate is not required for its intrinsic qualities, but because it contributes to the production of goods and services. As output increases so, after a lag, does the demand for real estate and its price. However, the influence of the macro-economy on real estate is much more comprehensive than this. Macro-economic conditions affect the level of interest rates and, most importantly, the market discount rate. This boosts values because a positive sequence of macroeconomic events tends to reduce the premium investors require for holding risky assets such as real estate. On the supply side, a rise in economic confidence tends to increase the supply of finance to the real estate development industry, increasing the rate of new construction and, in the future, the level of vacancy in the marketplace. When growth is too strong and inflation builds up, investors acquire real estate because of its putative ability to hedge inflation. For all of these reasons, we have devoted considerable resource to examining, over time and between countries, the precise impact of GDP growth on real estate returns. The general discussions of GDP growth and real estate performance are in the articles of: November 2001; January 2004; November 2004; and January 2010. Interestingly, in the article of November 2004, our commentary picks up the fact that the US economy was being over-stimulated by monetary policy which, as we later found out, was a significant factor in the sub-prime crisis that developed later.

Our general approach to interpreting macro-economic events for the purpose of forecasting real estate markets may be termed ‘output gap monetarism’. This view sees aggregate demand as fluctuating about a rising trend of supply. In situations where aggregate demand is above aggregate supply, inflationary conditions exist and central banks use monetary policy (mainly interest rates) to slow economic growth. When aggregate demand is below supply and a negative output gap exists, inflation starts to fall and interest rates are cut. Fiscal policy, subject to micro-economic and political objectives, may also be pursued by governments to augment or restrain demand. Central banks generally have symmetrical inflation targets, meaning that overshoot and undershoot are, at least officially, considered equally undesirable. Unofficially, Japan’s long struggle against deflation and recession has probably seen a greater fear of deflation than inflation in OECD central banks over the last 15 years. This fear has been magnified by a long series of positive supply shocks in the global economy, which have delivered an extended period of low-inflation growth but also, from time to time, the real threat of deflation. In the articles of December 2001 and October 2002, we discuss the possibility of deflation taking hold in the global economy. The former article concludes that a deeper recession would be required for such an event to occur. The GFC, six years later, was just such a recession. That later made one of the first attempts to consider the implications of deflation for real estate returns; a theme others have considered in depth in the last three years. In January 2010 and March 2010, we examined the way in which central banks have targeted asset markets, including real estate, to force the pace of recovery in deflationary conditions; our tentative conclusion is that an asset market revival provides a relatively ephemeral boost to economic activity.

Economic cycles are seven to eight years long, on average. In our framework, this means two years of rapid growth with relatively high unemployment, as the economy moves out of recession; two to three years of trend growth and falling unemployment; two years of rapid growth and accelerating job creation; and, finally, two years of falling output and rising unemployment. The article of July 2001 deals with the recovery from the relatively mild recession of 2001 and makes some interesting points about how economic weakness in one country is quickly transmitted to another in the modern era, because of globalisation. The progress of the recovery from the 2009 recession is considered in the article of January 2011. All of these articles demonstrate that, in their early stages, recoveries are volatile and uncertain. From a real estate perspective, one of the key indicators that a recovery is gaining traction is an upturn in business investment, because it signals the fact the businesses are confident to expand and take additional space. The articles of December 2002, July 2003 and January 2010 deal with the resumption of investment following recession. The path of economic growth is rarely quite as smooth as earlier comments suggest and most economic cycles have a mid- or late-cycle ‘hiccup’. This is a slump in asset markets and economic activity that feels like a new recession, but actually isn’t one. The article of November 2004 deals with a mid-cycle hiccup, although the writer does not quite realise it at the time.

The savings rate is the proportion of national income that is not spent in the current year by consumers, businesses and the government. It is an important variable in the analysis and forecasting of real estate markets, because of its close correlation with consumers’ spending, in particular, on retail goods. As consumers become more confident after the end of a recession, they save less and spend more. At the peak of the cycle, consumers can become over-confident and spend too much by dis-saving and taking on debt. This happened in extremis in the economic boom of 2004 to 2007. Consumer confidence is related to a number of factors, but the most important ones are unemployment (or job growth) and asset values. As the economy moves through the cycle, unemployment falls and asset values rise, which drives rising consumer confidence and falling savings rates. Other things being equal, retail markets are safer, with greater growth prospects, in countries where the savings rate is high than where it is low. The articles in September 2002 and December 2009 deal with the causes and consequences of movements in the savings rate.

The framework outlined above posits the cyclical movement of demand around the rising trend of supply, generating GDP growth. There is another source of GDP growth: positive and negative economic shocks. Economic shocks can substantially raise or lower the level of aggregate demand or aggregate supply. Positive supply shocks might arise from technological developments such as the internet, which has substantially improved productivity or geopolitical events, such as China acceding to the World Trade Organisation. The latter brought a vast, hitherto untapped pool of labour into the world economy. In turn, the relocation of manufacturing activity to that area has created scale economies in production. The formation of the Euro zone, in that it has to a certain extent enabled a degree of industrial restructuring in Europe and greater scale economies, is also a supply-side shock. In any case, from a real estate perspective, it is important to distinguish an economic shock from a cyclical movement. The latter implies a temporary change in the rate of growth of the economy, the former suggest something more permanent which might affect user demand for real estate assets. In October 2000 and October 2005, we looked at the consequences of rising oil prices – creating both a supply-side and demand-side shock. We have tended to conclude that oil price movements are far less influential in the global economy than they were in the 1970s. However, we note in passing that there remains quite a strong correlation between raised oil prices and economic weakness, which suggests that oil prices are more influential than currently supposed.

The GFC is not commonly considered a negative supply-side shock, but this is what it is. The need to recapitalise the global banking system and, to an extent, improve the regulation of it, is substantially impeding the ability of the financial sector to lend to businesses. Our August 2010 article deals with the post-crisis developments in banking markets and, presciently enough, points to Europe as being a source of further instability.