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Chairman's Letter July 14, 2010 Risk aversion in global markets once again reared its ugly head in the second quarter – reminding us all of the significant headwinds the global economy still faces as we struggle to recover from the recession brought on by the global financial crises. The trigger for the current sell-off in global equity markets started in Europe with concerns that Greece was on the verge of a sovereign default and would need to restructure its outstanding debt. These same fears eventually spread to both Portugal and Spain and markets began to fear a possible break-up of the Euro and resulting credit losses by major European banks holding debt of these countries – similar to the US sub-prime crises. The Euro currency came under attack, with the Euro at one point falling below 1.20 to the US dollar. European authorities however responded in dramatic fashion to contain the crises through the creation of the European Stabilization Mechanism (ESM) providing in excess of $900 billion to support countries in need of liquidity. The European Central Bank (ECB) also played a key role by agreeing to purchase the debt of Greece, Portugal and Spain, driving spreads back down and calming market fears. But the damage had been done and many European governments fearing further market turbulence, resolved to begin to bring down their growing deficits through a combination of budget cuts and tax increases. With consumer demand already sluggish throughout much of Europe, such an early move to tighter fiscal policies is likely to lead to a long period of slower growth across the region. I spent much of the month in June traveling in Europe meeting with investors and discussing the outlook for the US commercial real estate market. I thought it timely to share some of the observations I took away from that trip, which began with a week in Germany meeting institutional investors. I then attended a large investor conference in Monaco that focused on family offices and high net worth individuals from across Europe. My first observation is that reports of the demise of the Euro are greatly exaggerated. European leaders have taken decisive steps to stabilize markets. Indeed over the last two weeks we have seen stability return to the European debt and equity markets and the currency move back above 1.25 against the dollar. A key next event is the release of the European wide bank stress tests scheduled for later this month. Second, while growth across Europe will certainly be slowed by ongoing fiscal adjustments, some countries will be hurt more than others. Germany, Europe’s largest economy, stands to benefit from the weaker Euro given its strong manufacturing base. The Euro is down approximately 20 percent since December against many currencies and this is helping European exports. A key German leading indicator of manufacturing reached a two-year high in June and Industrial Production reports in May for Germany, Italy and Spain all showed that manufacturing was benefiting across the region from strong export demand. JPMorgan has estimated that the boost to exports from the weaker Euro – particularly to Asia – could add as much as 1 percent to GDP growth across Europe. Third, there seems little doubt that to counter the fiscal tightening that has begun in Europe that monetary policy will need to remain accommodative. It is likely that the ECB will be on hold for an extended period of time. German Bund ten-year yields reflect this new normal and closed last week at a yield of 2.6 percent. What does this mean for capital flows and investments into US commercial real estate markets? With long term interest rates now painfully low in Europe, investors are being forced to seek higher returns elsewhere. The one message I heard in my meetings is that European investors are sitting on large amounts of cash and searching the world looking for new investment opportunities. For many of the investors to whom I spoke, prime US commercial real estate properties look attractive compared to European commercial real estate markets. Several large institutional investors in Germany already have plans in place to increase allocations to US commercial real estate this year. Multifamily properties in particular were an area of interest in many of my meetings as investors are more focused on steady income flows rather than capital appreciation. I think it fair to say that European investors have a cautious view on global growth, reflecting the recent market turmoil in their home markets. I answered plenty of questions about the risks of a double dip recession in the US and the potential impact on the commercial real estate market. In that regard, some investors voiced caution about the recent cap rate compression we have witnessed in sales of Class A multifamily properties, as having come down too quickly without clear evidence that the unemployment rate has bottomed in the US. Investors also remain cautious about distressed plays and were dubious that returns of 15-20 percent could be achieved without taking significant risks in smaller, less liquid markets and this offered little interest to the larger institutional investors with whom I spoke. Finally, most of the investors I spoke with are expecting an extended period of Euro weakness – after all, the Euro has had a long bull run against the US dollar from a low of .85 in 2000 to a high of 1.60 in 2008 and was still over 1.50 just last September. Many institutional investors, both in Europe and Asia, have been overweight investments in Europe, and as the unwinding of these positions will take time and will be supportive of capital flows into US assets. As always, I look forward to discussing the views expressed here and Capri’s outlook for commercial real estate markets as I meet with many of you over the remaining summer months.
Quintin E. Primo III |