Trends Watch: October 19, 2017
EisnerAmper’s Trends Watch is a weekly entry to our Alternative Investments Intelligence blog, featuring the views and insights of executives from alternative investment firms. If you’re interested in being featured, please contact Elana Margulies-Snyderman.
This week, Elana talks to Kevin Kujawski, CFO & COO, Menlo Equities.
What is your outlook for real estate?
After an eight-year bull market for U.S. Commercial Real Estate (“CRE”), we are seeing the telltale signs that the run up in value is plateauing. At some point, a downturn is inevitable; however, we think the probability of a significant downturn in 2017 or 2018 is unlikely. Conditions continue to be favorable in our technology-oriented markets with steady employment growth and strong capital flows. At the same time, we see CRE investment risk has increased in the last year. Buyer pools are thinner, and we are seeing less of the “feeding frenzy” that characterized CRE in 2015. We believe that reaching for yield will end badly for real estate investors who are relying on vacancy, renovations and turnaround strategies to create higher values and returns. Without doubt, the risk to values of all investment classes has increased over the past year. Given where we are in the economic cycle, Menlo believes it is a good time to protect principal and seek investments that can provide a secure and consistent cash flow. For these reasons, Menlo has only acquired one value-add investment in the last 24 months. We have also proactively pruned our existing portfolio of assets that are unlikely to hold their value if the eight-year bull market reverses itself.
What is your outlook for the economy?
Overall, our view is that the economy will continue to grow modestly through 2018, similar to what we have seen since the start of the recovery in mid-2009. We anticipate that interest rates will continue to rise, but at a pace considerably slower than what the Fed’s statements indicate. The period of extraordinary monetary policy following the financial crisis is coming to an end. Interest rates are still near all-time lows, but there is a pervasive view within the Fed and the broader market that a return to rate normalization is prudent at this juncture of the economic recovery/expansion. What is not clear, however, is how aggressive the Fed may be in trying to normalize rates in the near term. We believe it is unlikely the Fed will be able to raise short-term rates as fast as they have recently indicated given the lack of inflation drivers and their desire to maintain a healthy housing market. We are carefully watching the spread between Two-Year and Ten-Year Treasuries (which is currently very narrow by historical standards). We have seen the yield curve continue to flatten as the Fed has acted, so it will be interesting to see how far they are will to push their policy of tightening.
What keeps you up at night?
Our biggest near-term concerns are:
- The impact on asset pricing and economic velocity of a coordinated reduction in quantitative easing by the major central banks. The forthcoming Fed balance sheet unwind is uncharted territory for the leading global economies. We are essentially going to see a large reduction in the demand side of debt offerings if they truly begin to unwind their holdings.
- The level of U.S. corporate debt in the global economy today. We have seen U.S. corporations increase their debt from $5.3 trillion in 2007 to $8.5 trillion in 2017. With the Fed being a major buyer of treasuries (17%) and mortgages (30%), crowding out typical institutional buyers, much of this debt has been acquired by global institutions. With a large portion of the proceeds of this debt used to repurchase stock vs. true growth oriented purposes (CAPEX or R&D), we are concerned with how this debt load will be borne in a higher interest rate environment.
- Tax reform and its possible impact of the real estate industry. Lots of ideas around removal of the interest rate deduction to immediately expensing capital expenditures have been expressed. Some of these could have a material impact on the after-tax cash flows generated from real estate investing.