By Scott Aiese
Global uncertainty is driving capital flows into the United States, lowering U.S. Treasury rates and funneling debt and equity into New York City.
The United Kingdom’s vote to leave the European Union – Brexit – has affected markets globally as investors grapple to understand the potential implications of this historic decision. How will the U.K. conduct business with the EU? Will the U.K.’s exit spark France, Holland and Denmark to hold referendums against EU membership? Will Scotland seek independence?
Since the Great Recession, we have seen domestic and international economic turmoil lead investors towards markets that are perceived as safe havens for capital preservation, specifically U.S. Treasuries.
The term “flight to quality” describes the action of investors moving their capital from riskier investments to safer investment vehicles and became popular in 2009 when global investors poured capital into the United States despite a collapsing U.S. financial system. In August 2011, when the U.S. Treasury was downgraded by Standard & Poor’s 500 index from AAA to AA+, economists were shocked as capital again flowed to the U.S. from more volatile markets, representing an example of flight to quality. In both situations, in the face of economic and political uncertainty, global bond buyers still chose the United States over the rest of the world as a safer market in which to invest.
Today, history repeats itself as global investors shift capital to the United States and away from riskier markets. As a direct result of the Brexit decision, the pound hit a 31-year low against the U.S. dollar, and markets question the future stability of the 27 member EU bloc without the U.K. At the same time, government bonds issued by Japan and Germany (the third and fourth largest global economies, respectively) are trading at negative interest rates, and there is continued and widespread political unrest in the Middle East. The U.S. again benefits from a flight to quality as global investors look towards U.S. government bonds as a safe haven while searching for yield.
As bond buyers seek a safe haven, the 10-year U.S. Treasury has plummeted to 1.47 percent, down 1.01 percent from a year ago and .40 percent from a month ago, as of writing. Meanwhile, it is the highest amongst all of the G7 countries, providing bond buyers with compelling relative value. As global bond buyers search for yield, commercial real estate investors do the same. However, falling Treasuries lead to downward pressure on cap rates as the gap widens between historical cap rates and the spot Treasury rate; this gap represents the commercial real estate risk premium.
The New York City real estate market will benefit greatly from the continuation of flight to quality as foreign investors remain attracted to NYC’s robust economy and population growth. According to the U.S. Bureau of Labor Statistics, the NYC Metro area is the largest employment market in the country, with 9.5 million jobs.
NYC has led employment creation since the economic trough with nearly 1.2 million new jobs (No. 1 MSA with over 400,000 additional jobs than its nearest competitor, Los Angeles), 143,000 of which were in the past 12 months through May 2016, making NYC No. 2 in job creation only behind Los Angeles by 10,300 jobs. Population trends support this thesis with the 2015 census estimating the NYC population at 8,550,405, which reaches the 2020 population prediction set by the Bloomberg Administration in 2013. We should expect population to continue to exceed the mayoral expectations, including the 2013 projection of more than nine million people by 2040, due to NYC’s younger industries gaining further momentum (life sciences, technology); international brands moving their headquarters to NYC to attract talent (e.g.. Cadillac); venture capital climbing 38.7 percent YOY in 2015 to $7.3 billion, trailing only Silicon Valley (according to the NYC Controller’s office) and the suburban-to-urban national trend gaining momentum among empty nesters and millennials.
Another element driving capital to the NYC market is the availability of debt, where the fixed mortgage market continues to be priced at all-time lows. As Treasury rates continue to drop, long-term lenders can only follow so far before implementing floors to all-in coupons.
A recent HFF survey of 17 life company lenders revealed that 77 percent of those lenders have set all-in coupon floors greater than 3.25 percent on 10-year, fixed-rate mortgage loans. As long-term mortgage lenders determine their minimum acceptable rates, they think about relative value of mortgages versus alternative investments, most notable BBB+ corporate bonds. One a daily basis, HFF tracks these rates, which generally fluctuate at 200-250 bps above the corresponding U.S. Treasuries.
While the debt markets stay active, the commercial real estate market will remain an ideal investment class for investors in this interest rate environment – where investors can readily generate high single-digit returns. For example, commercial real estate investors today can generate a 9.4 percent cash-on-cash yield by acquiring an asset at a 5.5 percent cap with 10-year 65 percent leverage at 3.4 percent on an interest-only basis. If rates stay low and mortgage capital remains abundant, we should expect cap rates to further compress.
As global political and economic volatility remain prevalent, New York City will continue to benefit from a flight to quality by lenders and investors attracted to the city’s positive economic and demographic drivers.
Scott Aiese is a Managing Director in the New York office of HFF, a leading provider of capital markets transactions services to the U.S. commercial real estate industry.