When MIT meteorology professor Edward Lorenz coined the term “butterfly effect” in 1961, little did he know it would become a popular metaphor for small events that cause major shifts in everything from pop culture to the global economy.
Lorenz’s famous study concluded that even the flapping of a single butterfly’s wings on one side of the globe could produce a massive storm on the other side. Among commercial real estate investors, the butterfly effect is causing changes in investment behavior and sentiment, and creating a growing sense of confusion about what macro factors really matter.
Today, it is more than just a single butterfly causing change. Hyperconnectivity and the instant delivery of information have sent trillions of them aflutter, and it seems that now more than ever the talk around the water cooler (and by extension the investment committee) is just as often about OPEC oil policy as it is about local market demand.
Butterflies impacting commercial real estate were evident in the past year, notably jitters in the Chinese economy that rippled into U.S. stock market corrections in August 2015 and February 2016. Of course this is a simplification to say that it was all China, as the situation was exacerbated by slowdowns in U.S. manufacturing and corporate earnings, and a drop in oil and gas capex. But most commentary pointed only to what was happening in China as the proximate cause of U.S. stock market volatility.
As evidenced by the rapid snapback in the equity markets, these were clearly massive overreactions to a butterfly of information in China, but the damaging impacts have lingered in the form of lower bond yields and materially diminished business sentiment. Despite these ripple effects, should these events have any impact on the decision-making of the commercial real estate professional? In short, does all of this new information really matter or is it just background noise?
Information has never been so extensive and easily available. IBM estimates that 2.5 quintillion bytes of data are created every day and that 90 percent of the data in the world today has been created in the past two years alone. And this speed is only going to increase. A recent study from McKinsey Global Institute projects that the flow of information will grow by nine times in the next five years in terms of “used cross-border bandwidth.” Big data is here; we now need to figure out what to do with it.
Information is measured both in breadth and in time. For those who are most concerned about time advantages, I encourage you to read Michael Lewis’ book Flash Boys, which reveals the hundreds of millions of dollars that some stock traders spend on infrastructure to gain a millisecond advantage in trade time.
While I have seen segments of the commercial real estate investment community embracing the commodity trading model recently, we have a long way to go before our industry makes decisions in milliseconds. In my opinion, each commercial real estate asset is and always will be unique, and woe to those who try to buy and sell via remote control.
Despite my view that we have too much information and don’t know exactly what to do with it all, hyperconnectivity and instantaneous delivery of information have had profound and positive impacts on commercial real estate markets.
The upside of hyperconnectivity is that it has greased the skids of global capital flows. Indeed, London, which, despite Brexit, is still perhaps the unquestioned world leader in global capital to commercial real estate, had more than 60 percent of commercial buildings purchased by foreign investors in the past 10 years.
Hyperconnectivity has also led to greater global diversification by investors who are now far more comfortable investing outside of their home countries, thus increasing the long-term safety of their portfolios. And it is also leading to equalization in pricing between similar assets in similar countries. Once you adjust for local inflation expectations, cap rates are remarkably similar for like assets in global cities.
Hyperconnectivity has led to more viable choices for global investors. While, historically, a disproportionate amount of foreign capital flowed to core office assets, the dominance of the office sector has been gradually eroding. Office held a 46 percent share of foreign capital investment in 2007, but today that share is down to just 35 percent as other asset classes such as hotels and industrial gain investor interest. The expansion of the asset-type target zone is good news for local owners whose asset values are now supported by a deeper base of potential buyers.
From my experience, the basics still work best. Some of the most sophisticated investors I know focus almost entirely on the “micro” (individual deal factors) and view macroeconomics somewhat dismissively given the difficulty of predicting the future. But when forced to choose one macro factor, invariably it is job growth that is the single most important star twinkling in the data universe.
Job growth as the “only thing that matters” is a simplification, but it is backed up by recent research by my colleague Serguei Chervachidze, which shows that in a deep recession scenario similar to 2008, with respect to office sector resilience, the degree of projected job losses is as important a factor as are a rise in rents and decrease in vacancy preceding the recession.
“Understand global optimism and you will understand how global investors make decisions.”
But even job growth, which many commercial real estate investors consider the most important single factor, is more than just cause and effect and is hardly an independent data event. Employers don’t add jobs on a whim and hope for the best. They decide to create jobs after weighing objective and subjective factors, including an assessment of demand for their products, the current and expected cost and availability of capital, and technological and geographic alternatives such as automation and different markets.
So while we are all searching the globe for the holy grail butterfly to make our investment decisions better, there is one common factor that underlies all: optimism about the future.
Optimism itself may be the holy grail. In macroeconomics, we forecast everything from GDP to interest rates to oil consumption. In commercial real estate, we forecast all fundamental factors, including rents, occupancy, and supply and demand. Each of these forecasts is influenced by investor optimism about the future.
In fact, optimism is the one common factor—the one common “butterfly.” Perhaps Nobel Prize-winning economist Robert Shiller conveyed it best when defining behavioral economics: Understand global optimism and you will understand how global investors make decisions.
17 September 2018 by Karla Pope
22 December 2015 by Daniel Rosen