Real estate, alternative real assets and other diversions

The major disruptor of retail is not the internet, but demographics An interview with Spencer Levy, Head of Americas Research at CBRE

Face to Face

Spencer Levy

Spencer Levy is the Head of Americas Research for CBRE, the property consultancy firm. A former real estate investment banker, he has been with CBRE for 10 years. Having trained as a lawyer he moved into business as soon as he could, taking the advice of his father, a lawyer himself, whose main piece of career advice was that five years was more than enough to be doing professional legal work. After some years as an investment banker, he had recently joined CBRE’s capital markets division when Lehman Brothers went bust in 2008. Levy’s boss told him he was now running the restructuring practice. His response was, “We don’t have a restructuring practice.” His answer was, “We do now.” He has been responsible for the firm’s Americas research since 2014.

I start our interview, in the modish surroundings of the Mondrian Hotel, overlooking the Thames, just downriver from St Paul’s, by asking the obvious question. What did your father have against being a real estate lawyer?

He was a very good lawyer, a very well respected lawyer in town, but he liked being more of an advisor than being the lawyer behind the scenes writing up the deal. He liked to make the deal, not to document and facilitate the deal. So, that’s where my career has gravitated. I’m now very fortunate to be an advisor. I’m not just the Head of Americas Research, I’m also a senior economic advisor both to the company and to our clients. What I try to do is advise my clients on what to do, as well as some things not to do.

Give me an example of that, I say. Levy is a fast talker, bouncing from sentence to sentence – and thought to thought – in rapid order. He answers as follows.

In the last couple of months, we’ve had some terrible storms in North America, in Houston, Miami; and then we had the terrible earthquakes in Mexico City. There was a terrible human cost there – loss of life, loss of homes, that sort of thing. That’s the bad news. The good news is that the commercial real estate market was remarkably resilient. In the Houston office market, as an example, only about 4% of the market was down a couple of days after the storm, and then a week after the storm, only 2% percent down, and now it is very little. That was all due to telecomms and electronics, not the structural damage. It is the same story in Florida and in Mexico City.

I go to Mexico City a lot. In fact, I’m going to be there in about two weeks. When you go to Mexico City, you go in to an office building and you go to the corner of each floor of the office building, there’s something in there that looks like a giant washing machine. What it is actually is a shock absorber for earthquakes. When there’s an earthquake, it sounds like whale noises or the girders going in. But the commercial real estate sector in Mexico City was resilient. And you know what we can thank for that? The 1985 Mexico earthquake, Hurricane Andrew in the early 1990s, Hurricane Sandy in 2011. Because since then, the building codes in each of these areas has been continually upgraded so that commercial real estate is resilient.

So going back to my advisory role, when I heard people saying, “I’m never going to Florida again, I’m never going to Houston again,” I said, “Give me your number because I’m buying your stuff.” Because these markets are going to be remarkably resilient and Houston and Florida have tremendous growth characteristics to them for people flowing in – not just people that want to live there, but employers – that the commercial real estate, multi-family markets are going to be just fine in those markets because of it. They still may need some infrastructure improvements there, don’t get me wrong, but most of the real estate has proven to be resilient. That’s the key word.

Once a dealmaker, always a dealmaker, I suggest?

Yes.

So now you’re trying to give people research which is not just general waffle, but practical and specific to their concerns. An example?

Sure. I was just on stage [speaking at a conference] and people asked me, “What do you like to invest in? Which markets? Where are we in the cycle?” These are the questions you always get. And I say I think we’re asking the wrong questions. The right question to be asking is, what is the cost and duration of your capital? Because if the cost and duration of your capital is short-term, I’m going to give you a very different answer than if it’s long-term, intergenerational or otherwise. Some markets have had historically low cap rates, like London. But to say, “I can’t buy. London’s very expensive,” is the wrong answer. If you are an institution that has a long-term holding period, even if we are toppy in the cycle – and I will go so far as to say that – for the five, seven, ten year hold period beyond that, this is a terrific market and there are very few markets like it in the world.

It is literally the number one international capital market in the world for a reason. The reason is, it’s large, it’s liquid, it treats foreign investors the same as it treats domestic investors, for the most part. It has its own currency, it’s got a legal system which is one of the best in the world in terms of property rights. All these things come together to make this a wonderful place.

But not without its issues at present, I interrupt.

If I could put a little ‘please don’t do this thing’ in here, there have been some concerns recently in London about pricing, particularly in the housing sector. The only thing I would suggest is please don’t put restrictions on foreign money. I say that even though short-term you might face some additional price increases. I’m not going to duck that issue. There are social issues associated with that and I’m very sensitive to them. But over the long term, the one thing that keeps markets vibrant is international capital and everything that goes with it. And the things that come with it are jobs.

The one thing that keeps markets vibrant is international capital and everything that goes with it

We’re looking out of the window right now. Look at all those cranes out there [pointing across the river to Blackfriars and the City]. To me, that’s the sign of great strength. And that comes from money, not just here, but internationally. You want more of that. It brings not just the purchase of the asset, it brings development jobs which help local people, it also brings industries. Very often if you bring foreign capital from Asia, China, they’ll bring industry with it. They’ll bring people with it as well – students or other folks who want to live here.

When I go to markets that don’t have international capital, they ask me, “What should we do?”. I say, “Open up an office in Beijing or South Korea or Singapore and start talking to the locals and bring them there. That will get you to the next level.” London is there and they should cherish that position.

Does that mean, given your long-term horizon, that Brexit is just a blip? How does it look from where you’re sitting, on the other side of the Atlantic?

The initial take on Brexit was, as you know, very negative on its impact on the UK and none of that has come to pass yet. I know the negotiations are still underway and I’m not certainly going to comment on which way the negotiations are going to go from a tactical standpoint, but from a big picture, long-term investor standpoint, all of the characteristics of London that existed before will exist tomorrow – with a couple of notable exceptions. The exceptions are the flow of people to the market. And the flow of people to the market is really significant, most notably for the tech industry – not as much for financial services, but especially for the tech industry. The financial services industry question is: will they be more efficient in Dublin or in Frankfurt rather than here? But I worry the most from a talent flow standpoint and whether it will retard long-term growth in the market.

The talent issue is enormously important. We recently came out with our Tech Thirty Report, which talks about the best markets in North America today for tech companies. They all have certain characteristics. They have large, research-oriented universities, they have 24/7 markets, they have transit-oriented developments, they have live-work-play. The markets that come in the top 30 in the US will be no surprise to you. London has all of those characteristics. But if you restrict the flow of people physically able to work here, people are going to have to make other decisions. The scarcest thing in the world is high-skilled talent.

The second scarcest thing in the world, from an investment standpoint, are large, high-yielding investments, which is another reason why London is attractive. It has a lot of those. So there are certainly some negatives to Brexit from a talent standpoint, and a question mark over the potential relocation of some elements of the financial services industry, but I do think it’s a short-term phenomenon. I think long-term the positive elements that make London a terrific market today will continue, even if in the short-term there is increased uncertainty.

So increased uncertainty, if it has an impact on property prices, would be an opportunity?

Well, yes. You would think that when the pound is weak, or the US dollar is weak, that the market would be on sale. People would flock in there. It’s actually the opposite. The London market bounced back when the pound bounced back, and in the US market, the dollar has been weak this year and sales have been down. What people like to do is go into the market with a strengthening currency. That is because a strengthening currency means a couple of things. It means a growing economy, it means increasing interest rates, it means a few things that are buoyant. Also, if you’re looking from an international investor standpoint, there is always the issue of whether they are going to hedge it or not. People who are not going to hedge their money will want to go into an appreciating currency market.

Give me a snapshot then, I say, on the dollar and commercial real estate capital flows to the States at the moment.

We’re down. We’re down this year, we were down last year as well. And the dollar, while it has bounced back somewhat in the last couple of months, it’s still down from where it was at the beginning of the year. And the reason why the dollar is down from where it was at the beginning of the year is because growth expectations have tempered. The best indicator of that is the ten-year Treasury, which I think is the single best indicator in the world of what the risk-free rate is. The yield on the 10-year is exactly where it was at the beginning of this year. Even though it spiked up 2.63%, it got down to 2.07%, and now it’s about 2.31-2.32%. So the prognosis for growth in the US is more tempered today than it was at the beginning of the year, which has weakened the US dollar and partially why it has weakened transaction flow.

But there’s a second really important reason why transaction flow is down a bit in the United States, and that is because notwithstanding the relative uncertainty in the equity capital markets, in the sale markets for assets there has been tremendous strain from the debt capital markets. The debt capital markets in the United States are almost as deep and as liquid as they were at the peak in the market from a loan-to-value standpoint and conduit lending has not gone out to the same LTV. They have not got as covenant-lite as they were at that point in time. But overall, the market is deep and liquid and spreads are coming in on everything. Even for some more risky lending, like bridge lending, we see spreads coming in by 150 to 200 basis points over the last year.

The one area the debt capital markets in the United States that is soft is speculative lending for construction. In that segment, we’ve seen non-bank financial institutions enter the space to capture that. Even there, spreads are coming in, but not nearly as much as on bridge lending. So, part of the reason for the fall-off in capital or in sales volume is that the debt capital markets are strong. Why should I sell if I can park my money here for some period of time? But the other issue – and this has been an issue for many, many years – is if I sell today, what am I going to buy instead? So I’ll use the word again – there is a little toppiness in certain elements of the American capital markets that gives people pause. We’ve seen in certain major metros that rents are flattened, we’ve seen increased tenant concessions to get them into buildings, certainly in the office space, we’ve seen some overbuilding of multi-family units and multi-family rents softening and concessions increased in several markets.

Even though I’m giving you a general overview of America, there are different cycles depending upon asset class and market. One notable exception is Houston, going back to what we talked about before. Because pre-storm, the market was about 11% vacant, post-storm it is 0% vacant. Everybody that has a family-owned or stick-built town home has moved into the towers. Houston was actually in bad shape three years ago, in the midst of the energy crisis, the price of oil was 40 bucks a barrel, and so it went through its own recession. It’s still hurting from an office perspective, but it’s great from a retail perspective, from a multi-family perspective, from an industrial perspective. It’s doing great right now. Maybe they’re going to coast through the cycle better than other markets that have been a little toppier.

The single factor that I look at as the most important factor in American commercial real estate is office-using job growth and projecting that

The single factor that I look at as the most important factor in American commercial real estate is office-using job growth and projecting that. Those markets that have a great amount of that we think are going to outperform the rest, not only in terms of NOI – net operating income – growth, but also, potentially, cap rate compression. We have the usual suspects for growth – Dallas, great job growth, San Francisco, Seattle, great job growth. But there are also some unusual suspect markets like Phoenix, number two market for job growth, Orlando, Tampa, also in the top 20 for job growth. We like them not only because it’s going to have excess NOI increases, but because international capital hasn’t really discovered these markets to a great degree. There might actually be cap rate compression in those markets, even if we’re in a rising interest rate environment.

Taking a couple of those examples, I say, what sort of cap rates are investors looking at?

Let’s take the best asset in New York City or San Francisco. You’re looking at something with a handle of four [= above 4%]. And if it gets really competitive, it’s going to be a low four handle, possibly breaching that, in the best of the best. But if you go to the best asset – and again, this is in the office space – in Denver or Portland, Oregon, for the best of the best, you’re probably in the mid to high fives, probably over six. For the best of the best, you can always get slightly lower than that. So you’re talking about, call it a 150 to 200 basis point discount to go into some of these markets in the office space.

The multi-family space is much tighter. The spread differential between a major office multi-family tower in mid-town Manhattan versus one that is in, say, Richmond, Virginia, which is a real secondary market, the spread differential might be 100 basis points versus 200 basis points. The reason is very simple. The debt capital markets in multi-family in the United States is by far the most liquid market because it’s got government-sponsored debt from Fannie Mae and Freddy Mac, which can spread your loan-to-value up to 75% or higher, where for traditional buildings your loan-to-value has to be lower than that. Of course the price per square foot is substantially higher in New York than it would be in Richmond. I’m talking about a current yield basis.

Are your projections for yields to stabilise or increase, albeit slowly, which seems to be the consensus, I ask?

This is my favourite topic. I call it the holy grail of real estate, which is the relationship between the ten-year treasury and average cap rates. I think people have been trying to find that for quite some time, as have I my entire career. I’ll start with a joke against myself, if I can. For the last seven or eight years, every time somebody asks me that question they say, “Where is the ten-year Treasury going to be this time next year?” And for seven or eight years in a row I have said, “100 basis points higher next year than this year.” And I have been wrong seven or eight years in a row, just like everybody else who does what I do, on Wall Street!

Partly because of that and partly because of some additional analysis, I’ve changed my point of view. I need to be clear that there is a difference between my house point of view and my own point of view. My house point of view is that the ten-year Treasury is going to rise to about 3.0% sometime by mid next year, and that is a possible and maybe the most likely scenario. But my view differs from that somewhat because I believe that there has been a massive secular shift in the marketplace. It is called the excess supply of capital. And the excess supply of capital is coming from Germany, Japan, China, elsewhere. Excess savings have to be put somewhere, and that is going to be into large, high-yielding investments around the world. It is that which is depressing cap rates, which are depressing interest rates and other factors.

There is a terrific book by Daniel Alpert. It’s called The Age of Oversupply, and he talks in great detail about the two things in the world that are oversupplied – excess cheap labour and excess cheap capital. Both of them are upending our traditional notions of how interest rates, cap rates and other things might rise or fall. While I think the conventional expression is that interest rates will stay lower for longer, my expression is they’re going to stay lower for much longer, if not longer forever, because of these secular shifts.

Now, I hope that’s not the case. I really hope interest rates go up. I hope inflation goes up. Because the bigger risk in the world isn’t inflation, it is deflation. We need whatever we can do to stimulate the economy. The biggest thing that we can do right now in the US to stimulate it is if we get the tax plan done by the current administration. It is a massive question because the first nine months of our new president’s administration have been disappointing from a lot of perspectives, including – but not limited to – the ability to get policy decisions implemented into law.

The bigger risk in the world isn’t inflation, it is deflation

Now we are onto politics, I ask the obvious question of the day, which is whether President Trump will get a tax reform package through Congress.

Is it a sure thing we’re going to get this tax plan done? No, it’s not. But it better get done because as our Treasury secretary said on television the other day, “If we don’t get this tax plan done, the stock market’s going to correct.” By how much? We don’t know. But I think he’s right. Because I think [the tax plan] is priced into a lot of stocks in the United States. If we don’t get it done, when we talk about “when’s the next recession?” – the second question we get all the time – our house view once again, putting it on the record, is that the next recession’s going to start in about two years.

It is the most likely scenario based upon rising interest rates, rising inflation, and a job market which can’t get much tighter. But there’s something that can make it happen faster and something that could postpone it. What could make it happen faster is, in my opinion, if we don’t get a tax plan done. That will cause a major stock market correction and a drop in consumer confidence. But if we get a good, stimulative tax plan done, it could stretch it out beyond the two years that our base plan projects.

What are the chances that a deal will get done?

Look, I follow it very closely. I’m very close to all of the major real estate bodies in the United States that try to shape these types of things. The current draft of the plan – again this is a fluid process – maintained the ten-thirty-one exchange which is a major equity preservation tool in the United States. But again, this is the draft as of November 9th. It could change tomorrow. It has also maintained the existing depreciation rules, it has also maintained the existing rules on being able to deduct mortgage interest relief for most commercial property transactions, which were among the major issues that were of concern to our industry.

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