Roughly three months after the Fed announced that its third and final quantitative easing (QE) program was complete, the European Central Bank (ECB) finally announced that it was starting its first QE program. Given the effect the Fed’s QE program had on asset prices in the US, we examined the ECB’s new QE program and the potential investment ramifications for real estate investors.
ECB QE program details
The ECB’s new QE program began in March 2015 and will continue until at least September 2016. During this period, the ECB has pledged to buy €60 billion in bonds per month in an attempt to revive growth and ward off deflation. We use the phrase “until at least September 2016” because ECB President Draghi has stated that purchases will continue until the region sees a sustained increase in inflation close to their 2% target. At a minimum, this program will run for 19 months and include total bond purchases of at least €1.14 trillion. Some have said this is like pulling out a monetary “bazooka.” Those are big words, but this is a big program. While QE3 in the US was a slightly larger program at $1.59 trillion, there’s the possibility the ECB’s QE program will grow in size if they do not see a sustained increase in inflation toward their target to fulfill their mandate.
What ECB QE means for real estate investors
Real estate is often priced based on the yield it can offer compared to alternative assets. Today, the yields on bonds in Europe are almost nonexistent. In fact, many yields have turned negative. Imagine that scenario for one second…investors are paying borrowers to borrow more. But, that is exactly the mechanism by which QE is supposed to work: entice individuals and corporations with exceptionally low rates to borrow more and invest more to stimulate the economy and move away from deflation.
The obvious implication for real estate is that asset values are likely to rise in that scenario as investors take out mortgages to buy property. Further, M&A is likely to increase given the low rates that corporate borrowers can access. The ECB is purposely making it so attractive to borrow money and invest that investors will feel compelled to put idle cash to work. In turn, the hope is that increased borrowing and investing will spur greater growth in the economy.
Another, less obvious, implication is the potential for yield compression across the risk spectrum. Indeed, we saw this occur in the US REIT market during QE3.
The US experience during QE
In the months that followed the start of QE3 on September 13, 2012, REITs trended sideways for a short time before taking off as yields continued to compress. It was the higher-yielding assets that saw the greatest total returns, and we see the potential for this to happen in Europe. In the chart below, we compare a basket of the 20 highest implied cap rate stocks against the 20 lowest implied cap rate stocks in the US during QE3. You can see the disparity in returns is quite impressive. In just eight months, the highest implied cap rate basket outperformed the broader REIT market by double digits and the low implied cap rate names by over 20%. This ride came to an end in the middle of May 2013, when then Fed chairman Ben Bernanke uttered his famous “taper” comments about eventually winding down the QE program. This sent rates rising for a short period of time and thus ended the one-way run of yield compression and the market began to return to normal.
Source: Bloomberg; Heitman
1. Equally-weighted portfolio of the 20 highest implied cap rate stocks as of Sept-2012.
2. Equally-weighted portfolio of the 20 lowest implied cap rate stocks as of Sept-2012.
The big risk
By now you might be thinking this is too good to be true for investors. However, there is one big risk to be aware of, especially for global investors, and that’s currency risk. In the mere six-week time frame between the announcement of QE and the commencement of QE, the euro depreciated against the dollar by just over 5%. While asset values in euro terms are expected to rise, we caution investors that those gains could be offset by a decline in the euro for those investors outside the Eurozone.
The ECB has put €1.14 trillion on the line in order to nudge you, or perhaps shove you, to invest in riskier assets. While we continue to like growth stories like the London specialists, we are also looking closely at peripheral countries and secondary assets such as Ireland, Spain, secondary markets in France, and Italy. With improving growth and historically low interest rates, you are not likely to see a much better time to invest in European real estate than now.