Chinese investors and developers are targeting smaller, higher-quality real estate assets in Australia in response to Beijing’s recent restrictions on capital

What’s likely to happen with commercial and residential real estate in the SF Bay Area over the next few years (as of May 2016)?

Summary

Real estate market in the San Francisco Bay Area (and other locations favored by “hot money”) will likely undergo a correction over the next few years due to the following factors:

  • U.S. credit cycle has likely peaked, and further monetary policy tightening would induce investors to move down the risk ladder and focus on liquid investments (real estate investments are “liquid until they are not”)
    • A large number of technology start-ups in Silicon Valley or Silicon Beach are too high up on the risk ladder to receive affordable funding during a funding crisis or deleveraging event
    • “A few” Fed policymakers recently warned of “rapidly rising prices of CRE” and called for a rate hike in June
    • Sustained asset price appreciation is now featured more prominently on policymakers’ radar, and those who expressed concerns include a policy dove who supported policy easing throughout the past 8 years (and typically more dovish than Chair Yellen)
  • Prime U.S. housing markets including San Francisco Bay Area are overtly reliant on foreign buyers, and built-up of excess risk-taking from abroad will likely dim foreign risk appetite for U.S. assets (they are more vulnerable to a risk-off event, as any deleveraging / credit event will strengthen the dollar, which is the reserve currency and de facto funding mechanism)

One macro trade, many sectors

San Francisco Bay Area real estate is a microcosm of broader high-quality assets in the U.S., and its trajectory will likely depend on the various fund flows behind current valuations in other asset markets, such as equities, fixed income, and alternative investments. As a result, it would be unfair to single out San Francisco Bay Area real estate as a unique phenomenon, because it is also happening in West LA, Pasadena, Austin, Atlanta (Buckhead area), Orlando, Vancouver as well as other high quality asset markets, such as U.S. Treasuries, Agency Mortgage Backed Securities, and German Bunds.

The past 8 years was a demonstration on the power of credit easing, as easy funding conditions not only turnaround the post-2008 deleveraging wave but also ignited investors’ animal spirits. Institutions with access to easy credit can (and did) put funds to work. They come in the forms of foreign asset buyers, international VC, global hedge funds, and occasionally, private equity arms of major mutual funds. Equity markets rallied, corporate spreads tightened, and less liquid projects such as real estate development also attracted plenty of investors – many of whom from overseas.

Policy tightening and roundabout impacts on asset markets

However, the tide is slowly turning. Federal Reserve policymakers recently signaled their willingness to tolerate tighter (less favorable) financial conditions (which consists of short-term rates, long-term corporate borrowing cost, dollar valuation, and equity prices) ahead of further tightening if data do not disappoint.

This will not directly affect mortgage financing rates, which are correlated with longer term Treasuries outside of conventional monetary policy control, but tighter funding conditions will likely impact finances of institutions and individuals who are currently sustaining extraordinary housing prices in the San Francisco Bay Area and beyond:

  • Funding for high risk projects (such as tech start-ups) will decline as more higher-yielding, high-quality investment options become available. One explicit objective of monetary policy easing is to displace investors from traditionally safe investments (such as Treasuries) and into risk assets
  • Decline in demand for risk assets will drive down prices and investor sentiment, and companies operating under a high-risk model (limited cashflow, reliance on outside funding) will likely shed payrolls in anticipation of less enthusiastic sources of funding
  • Foreign investors (many of whom are from EM markets) will experience financial volatility (knock-on effects) within their countries of domicile, thus diminishing their risk appetite abroad (Reserve Bank of Australia recently highlighted concerns of a pullback in Chinese demand for real estate)

The decline of institutional support for tech start-ups began with VC firms and mutual funds (which are typically more conservative), and hedge funds (which tend to be more aggressive than mutual funds) are also going down the risk ladder by focusing on higher quality investment options:

In recent months, venture capital firms and mutual funds have become choosier about which technology startups they’re prepared to back. Now hedge funds, after helping push valuations to dot-com-era heights, are getting more picky, too.

Last month, hedge funds participated in the fewest number of venture capital rounds in U.S. tech companies since 2013, inking just two deals, according to research firm PitchBook Data Inc. Even Tiger Global Management LLC, an early backer of Facebook and LinkedIn with $20 billion under management, has pulled back. Smaller firms are getting out altogether.

Like VCs, hedge funds are more circumspect because some startups have failed to live up to their billing. Plus, in the wake of several disappointing tech IPOs, many of the most promising firms are choosing to stay private longer, meaning it takes longer to cash out. Investors’ stinginess is forcing startups to cut costs, fire workers and accept more stringent terms when raising money.

“We’ve completely stopped investing in private tech,” said Jeremy Abelson, a portfolio manager at Irving Investors, a small hedge fund based in New York. “I’m done with intangible valuations, unknown exits, unknown liquidity, and I want something that if I put my money into it now, I’m not going to hit a grand slam, but I’m going to get something that’s immediately yielding.”

Less plentiful funding would likely change start-ups’ projection, and a desire to maintain a consistent burn-rate would include trimming payrolls or hiring freeze.

Prices and affordability

It is true that demand for Bay Area housing is strong, and it will not disappear despite economic downturns. Nevertheless, demand for housing does not always translate into purchasing power. If foreign demand declines (which will likely happen concurrently with a tightening in domestic U.S. funding conditions), housing prices at this level will no longer make sense.

Below is a chart showing San Francisco area home prices as well as rental price inflation (OER). The decline in housing affordability (seen in the decline in home-ownership rate) is a result of asset price appreciation. This has also contributed to the rise in rental price inflation as potential homeowners become reluctant renters. Unless prices fall, this cohort of buyers will not be able to participate in the housing market regardless their desire.

Conclusion

Emerging evidences of tighter funding conditions will likely constrain demand for Bay Area housing. Cheap funding had enabled the rapid rises in asset prices, and the absence of such will likely exacerbate vulnerabilities of those who directly or indirectly support the sector.