As US real estate values continue to creep higher coupled with the Federal Reserve’s tightening monetary policy, some investors may get jittery as the impetus of the most recent financial crisis weighs on their minds and portfolios. Understanding where the US market currently resides within the real estate cycle prompted much chatter among market practitioners at NEPC’s annual conference, held in Boston on May 9 and 10.
“The [value of] property markets in core US on a blended basis today is 40% above the 2007 peak,” said Michael Yang, research consultant of real asset at NEPC, during a presentation. “On an absolute dollar basis, real estate looks somewhat expensive.” Further, even the secondary market valuations are a few percentage points above the 2007 highs.
However, the fundamental indicators underpinning a potential bubble have not yet signaled the market. “We are in an unusually long expansion cycle,” said Yang. Typically, real estate expansion cycles are between three to four years, whereas the current expansion cycle is almost twice as long. “Given all the underlying fundamentals and the [current state of] capital markets, we do think it’s closer to the peak, but not quite there yet,” he said.
Real estate values are principally driven by two key elements: capital markets and fundamentals. In terms of capital markets, there is a need for debt markets to finance real estate transactions as well as equity markets to capital flows into real estate. Various factors influence fundamentals, including the balance between supply and demand, and the ability to increase rents, which will drive value.
Signs of a real estate bubble approaching include:
- Supply overhang – overbuilding, which can lead to an imbalance between supply and demand
- Decelerating net operating income (NOI) growth
- Rising interest rate environment
Yang argued that generally there are not any current concerns regarding a supply overhang or decelerating NOI growth. Further, despite the Federal Reserve embarking on a tightening cycle, the speed at which the Fed will raise rates will likely be gradual relative to previous expansion cycles.
“If interest rates stay within a gradual range and stay within an expected range, then real estate values should still be okay,” said Yang. “The danger here is if we start seeing the Fed start increasing rates precipitously. In terms of the key signs to watch for, we really haven’t seen a ton of deep data that tells us there’s going to be a correction in the market in the next year or two.”
Yang recommended considering more niche strategies that can be more defensive and uncorrelated to broad economic factors and growth. For example, senior housing never experienced the same dips other sub asset classes faced during the financial crisis. “This is one example of focusing on more demographically driven sectors that can withstand a correction in the market better versus if you are looking at a more GDP-centric property type, like office, which requires broad growth in the economy.”
There has not been any key evidence there is going to be a shock to the system. “The housing bubble will probably be a little muted,” said Yang. “There probably won’t be a pop in the bubble, but maybe some air will get let out.”