The rising risks in commercial realty
Commercial property prices in London and New York soared in the past decade as the world emerged from the post-Lehman recession of 2008-09. Internet rates were rock-bottom due to easy-money policies by the Federal Reserve and the Bank of England, a tsunami of capital inflows from China, Russia and the Gulf eager to acquire trophy assets. Bankers were eager to lend against rising asset values and rental cash flows and corporate demand for prime leased real estate was robust. Yet the outlook for both London and New York commercial real estate has darkened in 2018. One, Brexit devalued London’s role as the financial capital market. The prospect of a no-deal Brexit has undermined the political stability of Mrs May’s Conservative government and led to a plunge in sterling to 11-month lows against the US dollar and the euro.
Two, the Federal Reserve has hiked interest rates seven times since December 2015. Short-term interest rates in the US will continue to rise in 2018 and 2019. Three-month Libor could well be 3 per cent next year, making it more expensive to borrow to buy buildings or other commercial real estate assets. Three, the demand for retail space has been gutted by the spectacular rise of e-commerce and sharing economy firms like Airbnb and WeWork. Technology has fundamentally changed the economics and tenant profile of office buildings, shopping malls, hotels and logistics assets. Four, the world’s leading commercial banks have begun to tighten underwriting standards and curb loan growth in their commercial property divisions.
Five, China’s anti-corruption crackdown, US sanctions on Russia and the oil crash impact on Gulf petrodollar flows have dampened offshore demand for trophy London and New York commercial property assets. Six, construction funding and mortgages on existing properties have led to a decline in the loan balances of money center banks like Wells
Fargo and JPMorgan. Seven, vacancy rates have risen in most retail and office segments as technology reduces demand for traditional brick-and-mortar real estate. Eight, default rates on commercial property loans have in London and New York have not rise but there is no doubt that the risk-reward calculus is not consonant with existing bank loan spread in a late cycle bull market. As bank funding costs rise, so will their reluctance to finance aggressively priced or capitalised property deals.
Data centres are the technological backbone of the digital transformation wave that is now a global trend. Equinix is the world’s largest operator of data centres in the world, a real estate investment trust (Reit) with revenues of $4.4 billion and a footprint on five continents.
I like this niche segment of commercial property for multiple reason. One, it has formidable technological and financial barriers to entry. A data centre can cost $500 million to build and requires access to state of the art telecom infrastructure. It is thus no coincidence that six major companies dominate the business, with the resultant oligopolistic pricing power. Two, tenant leases are long life and tenants have high switching costs, both features attractive to an investor in a data centre Reit. Three, data centre Reits exhibit secular growth, proxy for the spectacular growth of Silicon Valley, making them immune to more cyclical commercial property niches like shopping malls, hotels and apartment complexes. Four, data centre Reits tenants tend to be the best corporate credits in the world, such as Amazon Web Services, Netflix, Google and Alibaba. This means stable tenant credit, cash flows and lease growth profiles over time.
Five, data centre Reits offer reliable dividend growth to investors. Of course, as with other Reit segments, a rise in interest rates can mean a correction in share prices. Data centre Reits like Equinix borrow to build or acquire new assets, so higher borrowing costs can hit profit growth. Equinix, for instance, has a net debt of $9 billion since building a data center is a heavily capitalintensive business. Yet data centre Reits, if well managed, can deliver year after year of revenue growth. Equinix, for instance, just reported its sixth second quarter of successive revenue growth. This revenue growth is due to both the strong metrics of its operating business but also opportunistic mergers and acquisitions. For instance, Equinix bid for and acquired 29 data centre from Verizon for $3.6 billion.