GCC Focus – Losing and making money in commercial property

The sharp rise in US Treasury, British gilt, German Bund and other government bond yields is a disaster for real estate investment trusts (REIT’s) worldwide, including those in the GCC. In the $1.2 trillion US REIT market, prices of REIT’s investing in commercial property segments have fallen 20 – 30% from their 2017 peaks. Take, Equinix, the world’s leading data center REIT, one of the world’s most profitable, high growth property niches with such huge technological barriers to entry that only six firms dominate the market, a classic oligopolistic industry structure. Equinix shares have fallen 20% from their recent highs. Shopping mall REIT’s have been gutted by lower mall traffic and Amazon’s death star impact on online retail economics. In other property niches, such as self-storage and nursing homes, oversupply has added to low liquidity and higher financing costs to pressure share prices.

A rise in the risk free government bond yield increases the cost of borrowing to buy commercial property as well as lessens the present value of its future rental cash flows. Since most REIT’s cannot raise rental income from tenant leases at the same rate as the bond yields in capital markets, their profit margins compress. Bond yields will continue to rise as the Federal Reserve hikes its policy rate and shrinks its balance sheet amid an acceleration in synchronized global economic growth and higher US wage inflation. Property investors definitely believe in the Philips Curve even in the age of Alexa, Echo, robotics and digital money. It is a grim mathematical reality that a rising cost of debt increases the cost of owning property and so triggers a fall in property values. This is as true of trophy office buildings in New York’s Manhattan or London’s Canary Wharf as Dubai’s JLT and Business Bay, where vacancy rates are above 40% yet new supply continues to add to the chronic glut in office space. Oversupply ensures a protracted fall in rents and capital values in a given property segment, even in markets with no banking credit crunch, affordability or demand shrinkage issues, as exist across the GCC.

Strangely enough, hotel REIT’s on Wall Street are a relative safe haven in times of higher interest rates since they can quickly respond to higher interest rates by immediately increasing room rental rates. Yet this is not possible in any market where oversupply glut forces down the average daily room rate (ADR) and thus revenue per available room (revpar). Those selling offplan pieces of paper promising double digit hotel “yields” will hemorrhage money as 50 – 60,000 new rooms thus financed finally hit a glutted market.

The most fabulous opportunities in commercial property investing emanates from falls in supply demand shocks or charges in government policy that benefit owners. So when the Saudi government announced plan to double Umra pilgrims visas to 15 million in Vision 2030 and demolished/reclassified 25,000 rooms in the heart of Makkah, I knew this would be the most profitable four star hotel market in the Middle East on leased land in 2015 – and this is exactly what happened.

Brexit was nirvana for office space in Frankfurt, home of the ECB, the Bundesbank, Deutsche Bank and the German stock market. US banks, led by J.P. Morgan and Goldman Sachs, have scrambled to add space as they move hundreds of bankers from the City of London, as do Japanese banks. Ireland’s banking system was kaput a decade ago but now Dublin is the hottest Brexit hedge in Europe as the EU’s sole English speaking state. Limited office space supply but a surge in Brexit related demand from global banks means a surge in Dublin rents and deal ask prices.

A brilliant property developer/investor friend in Dubai took advantage of the Portuguese and Greek banking crash amid the Euro crises to snap up hotels and shopping complexes as low as 20% of replacement value in 2012. When such systemic crises hit, brick and mortar construction shuts down. Yet as economic growth returns and credit markets stabilize, as happened in Lisbon and Athens when Mario Draghi fired his monetary bazooka and midwifed the EC/IMF bailouts, my Dubai friend tripled his capital. Ideas make money and liquidity is like a cab on a rainy night. It disappears when you need it the most. This was a lesson taught to me by a New York banker who died a century ago – J.P. Morgan, founder of the bank that changed the world and once changed my life.

Market View – The Italian election and Europe’s financial fault lines

The meteoric rise of the far left Five Star Movement and the far right Lega demonstrates that populism has won in the Italian election, with the center-left Democratic Party of former Prime Minister Matteo Renzi hit hard. This means President Mattarella will nominate a Prime Minister who can forge a coalition and win a vote of confidence even in the huge, powerful Senate Tacitus and Cicero teach me that bitter factional infighting defined Roman politics two thousand years ago and nothing has really changed in 2018 in La Bella Italia!

While the Five Star Movement won the single largest party vote at 32.7%, the center right coalition (Lega-Forza Italia – Fratelli) had 37.3%. It does not help that Luigi de Maio has ruled out a grand coalition’s government led by Five Star in the campaign. If he changes his mind (he will. Power is a great aphrodisiac, as Dr. Kissinger said), he is Italy’s next Prime Minister. If not, the far right Matteo Salvini of the Lega wins the Quirinale Palace as the leader of a coalition with Berlusconi’s Forza Italia. This is a nightmare scenario for Berlin and Brussels as he is hostile to both the Euro and the EU. For now, this scenario is not discounted in the financial markets, though Italian equities and debt sold off after the election at the prospect of months of political posturing and policy paralysis. So Italy now joins Catalonia and Brexit as a political risk for Europe and reinforces my belief that Planet Forex will not easily challenge the Euro’s February 16 high at 1.2560.

The Italian election is negative for the country’s listed banking shares, as the rise of anti-Euro, anti-status quo parties threatens the fragile financial ecosystem of a nation that has witnessed the failure of two Venetian banks. A hung parliament and tensions with the ECB, EU, Berlin and Wall Street is hardly a reassuring formula for Italian bank stocks, particularly given their outperformance against their European peers in 2017. Since Forza Italia got only 14% of the vote, even a center-right government could be led by not Berlusconi but the untested, xenophobic, anti-EU ideologue Signore Salvini.

The systemic risk barometers of Europe do not flash a SOS for now. For instance, the Italian government debt credit risk spread over German Bunds spiked higher but returned to its pre-election levels. There was no contagion from the Italian election to either gold or global equities. In fact, the Dow soared above 300 points last Monday after Republican leader Paul Ryan pushed back on Trump’s steel tariffs.

It is premature to speculate about the economic fallout of the Italian election but a credible scenario would suggest fiscal slippage (populist love higher debt financed spending) and anti-Euro rhetoric by both Luigi di Maio and Matteo Salvini to galvanize their respective vote banks (as real on the Arno and the Tiber as on the Ganges and the Jumna!). In any scenario, Italian bonds will be the loser, especially since structural reforms are anathema to populist political parties. The resignation of Democratic Party leader Matteo Renzi, a proponent of reform, is a negative omen for the future.

The influx of African and mainly Arab/Muslim immigrants to Italy at a time of 11% unemployment accounts for the success of the far right Lega. Youth, unemployment in Sicily is a shocking 57%, higher than when Benito Mussolini seized power in his Fascist putsch. Italy’s relations with Germany and the EU will be acrimonious under both a Five Star (M5S) or Lega led coalition and financial markets will eventually cotton on that something is rotten in the kingdom of Denmark (actually Garibaldi and Cavour!) I expect bank bailouts, fiscal holidays, budget resources and government spending plans to poison relations between Rome and Brussels/Berlin. I also find it alarming that the Lega won 18% of the vote and has overtaken Forza Italia as the champion of the right and Salvini is now the coalition kingmaker since Fratelli d’Italia is too small to count.

While Milan outperformed STOXX Europe 600 in 2017, this may not continue as long as a credible, stable, government does not emerge. It is best to focus on Italian small caps correlated to the undeniably positive economic growth momentum or corporate restructuring stories like Fiat and Luxottica. The decline in the Euro will also benefit Italy’s vast family owned export firms in Veneto, Liguria and Lombardia.

Macro Ideas – Downside risk in India’s Sensex and Sri Lankan equities

I see a 2000 point correction in India’s Sensex as a high probability event this spring, a Basanti Bhaloo in Bharat Mata to the cognoscenti. Why? One, G-sec bond yields have risen 80 basis points and the 10 year note now yields 7.7%. Two, fiscal slippage is now the Achilles heel of Modinomics. Three, volatility on Dalal Street has risen alarmingly and option skews tilt to risk protection. The average Sensex correction since 1991 has been 18%. I repeat, 18%. Four, valuations are among the highest in the MSCI emerging markets index at a time when rising Uncle Sam bond yields and Federal Reserve monetary tightening could well compress multiples or even trigger a liquidity shock. At 18 times earnings, there is no place to hide when the music stops on Dalal Street.

Five, the Punjab National Bank corruption scandal (and the latest Ruia – Numetal/VTB bid for Essar Steel) has hit global investor sentiment. Six, bank stocks will underperform due to mark to market Treasury losses on their bond holdings. The 20% fall in SBI’s share price means, the Indian banking debt time bomb has not yet been defused.

Seven, Trump’s steel and aluminium tariffs will hit the prospects of Indian metal exporters – Vedanta, Hindustan Aluminium and Tata Steel. Eight, earnings growth has been mediocre at best. Nine, the Indian rupee can fall to 66 against the US dollar. Ten, FII outflows from debt and equity will accelerate. Ten, India’s 7.6% GDP growth rate means Modi’s BJP will win the 2019 general elections, but it will not be a clean sweep as the Rajasthan by election attests. Eleven, the 50% rise in Brent crude since last summer is a disaster for the Indian current account deficit, which will widen to 2%. Twelve, earnings growth prospects are mainly concentrated in PSU banks/metals, low multiple and cyclical low quality sectors. This is no argument for a multiple expansion on the Sensex. Thirteen, Modi has failed to create a mass manufacturing ecosystem in India. Even 70% of the incense sticks and statues used in Hindu temples are made in Vietnam or China. So get real. Get out. Get short. Sectors to hide? IT – note the 30% rise in Infosys and pharma.

I still believe India is the best domestic growth story in the emerging markets, with an equity culture whose epic local flows will offset foreign outflows. Fiscal 2019 could well witness earnings growth of 18% as the global markets focus on a second term for the BJP which hopefully will itself focus on economic reform and not social/communal/vote bank politics. India’s ostensibly secular DNA is just so attractive to someone who is one of untold million midnight’s grandchildren born on the other side of Sir Cyril Radcliffe’s bloodstained Award.

I was horrified to see images of a Sinhalese mob attack Muslim businesses and houses in Kandy. I have visited Kandy so many times in the past in spring to admire its sakura cherry blossoms, its ancient sites and its emerald green hill forests. Thankfully, the Sri Lankan government has imposed a curfew and deployed Special Forces in Kandy. Sri Lanka knows the blood price of ethnic conflict that robbed an entire generation of their youth in the horror of the Tamil Tiger secessionist revolt that began in 1983. I remember the civil war began with an anti-Tamil pogrom in Colombo from my teenage stays at the Galle Face Hotel. Communal monks must not let history repeat itself again – never again.

Sri Lankan shares were up 7% before this horrible event. I believe a sell off is a buying opportunity as the political elite in Colombo will not allow the ethnic pogrom to escalate. This is no Rohingya tragedy.