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NAREIM DIALOGUES SPRING 2017 3 & PUNCTUATED EQUILIBRIUM ANIMAL SPIRITS By Matthew H. Lynch Managing Director, UBS Realty Investors annual GDP growth rate of 1.9%, below both 3Q's 3.5% rate and expectations. 2016 annual GDP growth of 1.9% matched the disappointing 2015 result, and is just below the 2.1% average annual growth rate since the recession ended. The expansion is now longer than the historical average, but at an average growth that is the lowest since at least 1949. Observers have attributed the surprising market outcomes to animal spirits, somnolent for many years. The market appeared to expect growth to increase from major changes in fiscal policy, a reduction in regulation, and particularly tax policy. For the first time in three decades the sclerotic US tax system, which has an outsized effect on commercial real estate, stands a reasonable chance of meaningful reform. Some real estate fossils remember the revolution of 1986, the last time the tax equilibrium was punctuated. The proposals would be the most significant change since the Reagan administration, but the exact form of reform and their effects on real estate are difficult to assess. Other observers cite more common factors behind the rally, such as a recovery in earnings (acknowledging that reduced tax and regulatory burdens are meaningful), solid job growth, improved consumer and business confidence, higher inflation, and broad-based improved growth (including in Europe). What is likely is that observers have underestimated the time it will take for meaningful policy changes to be enacted. Perhaps animal spirits and punctuated equilibrium describe the change that is coursing through the US economy. As we enter 2017, the surprises of the past year have led 2016's "ninth inning" baseball simile to give way to this year's hockey's "second period" metaphor. The economic cycle appears poised to extend its lengthy low-trajectory expansion, perhaps with higher growth over the intermediate term, and we find that the following three broad themes describe our basic approach and outlook: • Our prediction that US commercial real estate returns would moderate from their double-digit level in core has been vindicated as total returns have stepped down to lower but still attractive returns—500 basis points returns plus inflation. The solid income returns of real estate provide an anchor to mixed-asset investor portfolios. Income returns remain well above debt levels and value-added transactions are still available with leveraged double-digit returns. Green Street estimates that commercial values rose only 3% during 2016. • At quarter end, the spread between US commercial real estate and the risk-free rates moved toward its long-term level, narrowing significantly as interest rates increased and cap rates remained flat, but remaining above the familiar touchstone of reasonable valuation levels of 200 basis points in at least one large institutional portfolio. Following the election the 10-year Treasury spiked 50 bps, settling at around 2.40%, unnerving bond markets, but ending near the rate of one year ago. Higher growth and inflation expectations increase the chances of an earlier Federal Reserve policy increase, but US rates are already higher than global rates, and real estate generally performs well relative to other assets in such an environment. • Commercial real estate fundamentals have entered a more normal phase with balanced aggregate demand and supply. The key net operating income (NOI) metric remains positive, settling at a lower level, reflecting higher vacancy in office, increased construction in apartments and improving retail income levels. As HVCRE (High Volatility Commercial Real Estate) enters the vocabulary, construction financing is increasingly difficult to obtain, suggesting that excess supply will not cause the end of the cycle. As appreciation moderates toward long-term levels, income-focused strategies should be seen as atractively cycle-resistant. 1 Keynes, John M. (1936). London. Macmillan. Pp. 161-62. 2 Gould, Stephen Jay (2002). The Structure of Evolutionary Theory, (Cambridge, Harvard University Press), passim. Source for all data, if not stated otherwise: UBS Asset Management, Real Estate and Private Markets. ©iStock.com/wwing ©iStock.com/Freder