Episode 339 - Prof. Stuart A. Gabriel, UCLA
The Impact of War on Commercial Real Estate
Today's Guest - Stuart A. Gabriel, Arden Realty Chair and Professor of Finance, Director of the UCLA Ziman Center for Real Estate
On today's episode, I welcome Stuart A. Gabriel. He is a Professor of Finance and is known for his expertise in the fields of real estate financing, economics, and navigating housing/mortgage markets.
Prof. Gabriel has previously served on the Federal Reserve Board's economics staff, as a visiting scholar at the Federal Reserve Bank, and on the boards of seven academic journals. He's also a thought leader in financial crises, housing distress, and macroeconomics.
Today, Prof. Gabriel and I explore a very important central topic: The impact of war on commercial real estate. In navigating this area, we explore conflict with Iran specifically, what developers could potentially expect from Middle Eastern oil production disruptions, the impact that cyber-warfare may have on markets, and much more. It's a fascinating, sobering conversation that you absolutely don't want to miss.
What You're Going to Learn
* What Conflict in Iran Might Do to Commercial Real Estate Interests in the USA
* What We Learn about Real Estate Economics from a World War One Assassination
* Understanding Real Estate Trends when Middle East Oil Production is Disrupted
* What to Expect from Interest Rates if the U.S. Goes to War
* The Ways that Cyber-Warfare May Impact Commercial Real Estate
* How to Understand Behavioral Economics in Times of War or Terrorism
* How Middle East Oil Conflicts Impact Commercial Real Estate
* And much more!
Listen To or Watch the Full Podcast Here
Conflict in Iran - What It Might Do to Commercial Real Estate Interests in the USA
Stuart: ... but getting away from massive physical attack, what would some sort of conflict with Iran look like from the perspective of the West, Western economic interests, and Western real estate interests? Well, there are basically two or three pathways. Pathway number one, for the sake of simplicity, we'll call 9/11. In pathway number one, as you know, a major iconic, global piece of real estate was destroyed in New York City.
Of course, implications not only for very immediate indicators of real estate in downtown Manhattan, such as office vacancy rates, all the rest, but also economic implications in terms of the way that we factor terrorist events and related exposure into insurance that corporations pay and into, bottom line, the pro forma that now may incorporate much more significant insurance premium, and the like.
There's a dimension here that relates to actual physical attack, which is isolated and terrorist-related. We've been told that there are Iranian agents, and cells operating in the United States that could be activated. They could be activated here, or in Europe, or in elsewhere, among other things, for purposes of terrorist activity and terrorist-related real estate damage. So, that's pathway number one; again, to repeat, sort of a 9/11 type of pathway, although perhaps a more moderate version of that.
Pathway number two is a more modern version of that. It's simply cyber warfare. Cyber warfare could hit, easily, major institutions of corporate America, as well as the U.S. government. In that particular respect, corporate America, increasingly, today needs to be totally aware and completely up to speed with respect to both cyber defense, cybersecurity, and related cyber relief.
That all is an exposure that corporate America is taking very seriously today with redundancy in platform, with disaster recovery capacity. Again, that flows to the bottom line in terms of the cost of doing business; would not necessarily have large-scale economic damage associated therewith, but certainly there is significant potentiality there.
What We Learn about Real Estate Economics from a World War One Assassination
Stuart: So, a third possible pathway could be a generalized economic pathway that filters through to the real estate sector, and to institutional-grade commercial real estate, and the like. The historic example which is being discussed here, in the context of the assassination in Iran - the Soleimani assassination - is out of the assassination of Archduke Ferdinand in Serbia as a pivotal sort of precipitating factor of World War I.
The interesting anecdotal note to that factor is that in the immediate aftermath of the assassination, there was not a perceptible financial market reaction; but actually some three weeks later, there was a market fall on the London Stock Exchange, as traders came to recognize that the very deep and dark clouds of war were forming over Europe, and that that war would involve major European powers, including the Austro-Hungarian Empire, Germany, France, Britain, et cetera.
There was some lagged effect there, and there are questions being asked currently about whether we're in this time frame of lagged effect. I can give you my own take on this, and my own take is that while we could be going to some form of active conflict in and around the Persian Gulf, in and around Iran, Iraq, Syria, potential attack on Israel - although I doubt that significantly - we are not going to World War III. One reason we're not going to World War III is that there's no one out there who is going to fight the U.S. over Iran. In other words, we're not going to see the Chinese deploy on behalf of Iran. We're not going to see the Russians deploy on behalf of Iran.
Anyway, we see a conflict here, where it's very disproportionate in terms of the capacity to use force; not to mention the fact that the U.S. have imposed very powerful economic sanctions on Iran. So, Iran clearly is wounded. It's dangerous because it's wounded. It is an advanced technological society that is not without significant capability, and capacity. Nonetheless, as I mentioned earlier, there's no answer to the U.S. Air Force or to all of the military technology that the U.S. has relative to very obsolete technology on the part of the Iranians. So, the Iranians really can't go that route.
The route that they can go is the route of sending some missiles into U.S. compounds in Iraq to using their proxy armies, including the Hezbollah in Lebanon, or the Hezbollah in Iraq, or the Houthis on the Arabian Peninsula, or others to attack U.S. or Western assets. The attack on the Saudi oil fields was an excellent example now pinned on the Iranians, clearly, of a attack meant to send a very deep and serious signal to global oil markets about risk, and so on, and so forth.
In all likelihood, it's going to be that, and in all likelihood, there's more of that coming that we haven't seen the end of this; and in all likelihood, there will be some form of U.S. response. So, we'll see how this set of back-and-forth goes.
Understanding Real Estate Trends when Middle East Oil Production is Disrupted
Stuart: Let's take the hypothetical here that we have an Iranian attack on Saudi oil fields again, or some such thing, and/or Iranian [inaudible] attacks in the Persian Gulf, or the Straits of Hormuz on global oil tankers.
The guess is that that obviously will cause volatility in equity markets. It will cause volatility in global petroleum markets; some rise in oil prices. It's not clear that there would be the type of rise in oil price that would be extremely hurtful to the global economy, based on the limited amount of oil that comes from that area and the fact that we could pump oil elsewhere.
Again, there's no cataclysmic scenario that I think we're contemplating there. But, in terms of this pathway, and getting back to real estate, the pathway is the VIX pops up in terms of a higher level of equity market volatility. That higher level of equity market volatility has to do with uncertainty about a military tit for tat. It has to do with some disruption in oil supplies, potentially. It has to do with just uncertainty about the pathway of White House policy or of Iranian policy.
All those factors begin to seep into an equity market, which is already, in the words of some equity analysts, priced to perfection. In other words, stock prices are high relative to historic precedent, and they're very high relative to precedent now. So, people are wondering how much higher they have to go relative to the downside risk. Well, we just have a new fundamental downside risk here.
How does that work again? Well, we could have some correction in the stock market. That creates some downward adjustment in wealth. We could have that coupled with a cyber-attack or a real terrorist attack that, again, creates high levels of volatility; again, creates adjustment in equity and fixed income markets that are negative; that, ultimately, over some period of time, with some transmission, feeds into the real economy; in other words, feeds into the creation of GDP.
As it does, it potentially affects those who lease space in major office buildings, or those who take vacations in major lodging projects, or those who are thinking about buying a house, or those who shop in retail centers, or whatever it happens to be. As we see net operating income of any of those projects begin to ease, there are property valuation implications.
What to Expect from Interest Rates if the U.S. Goes to War
Adam: If the economy- if NOI does start to go down and there is a depression in commercial real estate, then, "all the Fed needs to do is to reduce interest rates." But if there is a war going on somewhere, that potentially is very costly, so the government needs to spend to finance that. So, there's this counterweight that the only way they can borrow to spend is actually to increase rates. At the same time as needing to increase rates to attract more borrowing to finance a war, there's pressure to reduce interest rates. So, how does how does that balance, do you suppose, in a wartime scenario?
Stuart: Well, Adam, you bring up very good points. I think, again, what you and I are grappling with in this conversation is how do we define war? I think the way you've just defined war is really, in some respects, a major conventional engagement that, at least historically, has been associated with a major demand shift that relates to output of goods, and equipment, and services, and all the rest related to that war.
My own personal opinion is that we would expect less of that, at this moment, barring, again, a very, very serious, long-lasting major U.S. deployment back into the Persian Gulf, which I'm not sure anyone is quite talking about at this moment. Chances are, they can hurt us in an unconventional way through either conventional terrorism or cyber terrorism, the same way that we can hurt them, really, with a lot of our already existing capacity on the table. In other words, we've got a lot of idle military resources, be they human-manned aircraft, or be they drone-related aircraft. All this is a matter of just positioning, and kind of putting it on go.
That said, your point is very well taken in a slightly different way. Here's a story. When we discount NOI to create a valuation of a property, there's this question of where that discount rate or whatever comes from. That discount rate has two pieces. One is a risk-free rate, where that risk-free rate is driven, in some measure, by monetary policy and other such factors. In an extreme form of a war-type situation, you could see a Federal Reserve intervention; you could see some downward drift in the risk-free rate.
The flip side of that is that we have a risk premium, that, of course, is sector-, and geography-, and all the rest-specific. The combination, or the sum of the two - the risk-free rate, or the risk premium - is the denominator in that discounted cash-flow occupation. Now, at the same time, and for the same reasons that we would see a decline in the risk-free rate, we would also see an upward adjustment in the risk premium because of uncertainty, and volatility, and all the rest that could be embedded in the risk premium. So, it's possible that we could see effects of conflict in interest rates in different places for different reasons and [crosstalk]
Adam: -give me some 'for examples' of that. What would that look like, actually, you think?
Stuart: What would that look like? What that would look like would be a situation- this is, again, an extreme situation. This is a situation where a monetary authority decides to take action because of granular, substantive information - economic indicators, economic tea leaves - that show a real slowing in economic activity. In this case, the monetary authority eases and risk-free rates fall. The decline in risk-free rates, all things equal, or 'ceteris paribus,' as we say in economics, should serve to boost property values because the decline in the risk-free rate should translate into a decline in the cap rate. all things equal.
But there's a footnote. There's a caveat. The footnote is that, at the same time that the risk-free rate could be compressed, you could see an increased risk premium. It's the combination of the two that form the discount rate or form the cap rate. So, this increment in the risk premium could offset the decline of risk-free rate so as to leave discount rates or cap rates constant. In other words, the commercial property sector would receive less or more of a de minimis boost from the easing of monetary policy than might be expected.
The Ways that Cyber-Warfare May Impact Commercial Real Estate
Adam: Now, the way that I think of it- you mentioned cyber warfare on corporations and on governments. What I have thought about and think about in my day-to-day life is that here I am ... Stuart, I'm sitting opposite you with my computer, on which is my entire world - my banking, my business, my primary and only form of communication, if you take my phone into account, as well. If that went down, my world would stop functioning, especially if my banking stopped functioning. How would I buy groceries, or gasoline, or conduct the day-to-day activities?
Now, that's pretty bleak to imagine that happening, but it's not ... How far away is that from the potential of reality? If you've got a disproportionate military capability over a dangerous enemy, then the only way that they can fight you is an asymmetric- and asymmetric warfare. So, if we were to see cyber warfare in any way- let's say it's corporations, or governments, or credit ratings, or infrastructure, how do you suppose- how would somebody ...? Well, look, we can't predict it, so you can't really do anything about it. There's very little you can do in terms of real estate ... In this conversation, we couldn't say, "Sell this," or "Buy that," right? It's like [inaudible] If it was a stock market, you might be able to because you can buy and sell, but real estate is illiquid, so it's difficult to sell. Let's talk about what ways cyber warfare could, in different ways, impact commercial real estate.
Stuart: Well, you've articulated a very serious and major concern, and it's extremely broad-based. The issues that you described certainly could have some effect on real estate, but they would be very broad-based in their implications. I mean, there is- if you remember old-fashioned conflicts, groceries don't get delivered to grocery stores, and gasoline doesn't get delivered to gas stations. There's really a very basic set of issues, additionally, that need to be addressed.
Do we expect those things in this particular instance? No, we don't, especially not of the United States. But could there be instances where - let's pick a name - Social Security Administration is taken down, and those who receive Social Security don't receive their monthly check, or whatever? Certainly, certainly that's a possibility. I think there, for you and I, this is a moment for learning. The idea is that, very, very unfortunately, but very, very true, we've created a great dependency on all the things you've indicated, and we must be prepared.
You and I have very little insight as to the level of preparedness of, for example, federal government agencies, or county government, or state government, or people that do municipal services or something like that. But, across the board, this corporate boardroom focus on redundancy of platform, on disaster relief, on disaster recovery, on having every corporate executive and operative with an emergency laptop, with emergency power, with data on the cloud, somewhere in Utah, or Louisiana, or Greenland, or who knows where, where you can flip the switch, go to the auxiliary redundant system and, within 15 minutes, you're up and running. This is simply part of our reality.
If, indeed, there's one message of preparedness from our conversation, this is the message: that the day has long since passed, with respect to a lack of focus on the importance of such preparation. So, just as we prepare, like, for example, here in California ... I'm not sure about your house, but outside my house, we have big plastic garbage cans with earthquake supplies. We have another metaphorical plastic garbage can that relates to redundancy, and clouds, and cyber preparedness, and both are tremendously important.
Behavioral Economics in Times of War or Terrorism
Adam: After the events of 9/11, I recall there was an immediate slowdown for vacationing; that people stopped- in fact, you alluded to this before, that the hospitality industry was negatively impacted as a result of that. So, it was the perception that people had of danger, and of threats, and of economic downturn, as a result, that caused them to shrink in. There's another area, actually. So, that's one thing; that's an area to shy away from would be if you think that there is war of any sort, that will prevent people from going out into public areas and staying at home. So, one would be hospitality.
Another one is- when I was in Japan, I built movie theaters for Universal Studios. That's what they hired me to do. I built a chain of movie theaters. I recall that people sought entertainment. They were so resistant to the bad news that they were hearing that their instinct was to actually spend more on those things they were spending less on before, just to distract themselves from the angst of war. These are a little bit more easier to- more tangible ways that commercial real estate can be impacted. Do you want to chat about that for a few minutes, those ideas?
Stuart: Well, you're reflecting, I think, in a very interesting manner on many dimensions of what Keynes called the animal spirits, which is embodied, today, in something called behavioral economics or behavioral finance. It's a critically important dimension of what we do as academic economists - an increasingly important dimension - as we seek to analyze regularities and behavior that have economic consequences.
Let's take a couple of examples that you cited. The 9/11 event was an event about air travel, in terms of the way the event was perpetrated. Even at one point in 9/11, the entire air traffic across the entirety of the United States of America was grounded. Clearly, given planes crashing into major office towers in New York City, and into the Pentagon, and into a field in Pennsylvania, and the like, an animal spirit arose, a fear- of fear that related to the air travel; certainly in the immediate aftermath of 9/11, as we didn't really understand who these people were, where they came from; was this going to be replicated? Were there a bunch of other bad guys out there waiting to do it again next week or the week after, et cetera?
That coupled with the fact that any event of this sort creates high levels of uncertainty, creates maybe down time for business, or for economic activity, depending on where and what the event is about; can create some uncertainty about an economy that's growing at a certain rate, and there may be some, as we talked about earlier, some modest attenuation, or shock to growth. There was certainly a shock to growth that related to 9/11. It had some lasting effects. There's also, of course, some bounce back.
Everything that's embodied in those animal spirits gets translated into the economic realm. So, just as you say, if you seek more distraction in the form of close-by entertainment, if you seek more comfort in the home, if you seek less travel to far-flung beautiful areas that may be exposed ... If you recall, there have been terrorist events in the most beautiful areas of Java, and Indonesia, or wherever it is. So, all of a sudden, exotic, amazing places become scary.
Unfortunately, we live in a world, I believe, where this has become a regularity and, depending on how this interface with Iran goes, could be more of a regularity in coming months than less of irregularity. That will influence travel. It'll influence travel to the Middle East. It'll influence travel to anywhere near the conflict zone. Let us only pray that there isn't an effective execution of a terrorist event, cyber or otherwise, somewhere closer to home.
How Middle East Oil Conflicts Impact Commercial Real Estate
Adam: One more thing, if you don't mind - I'm interested in, and if you will forgive the pun, I'm interested in talking to you about the impact of warfare, particularly in the Middle East, on commercial real estate as it pertains- drilling down on - that's the pun - on oil. I, of course, immediately sprang into action and bought oil stock that day, which has now gone down. I was behind the curve.
You actually said that there was very little ... Because, of course, oil drives the economy, right? Oil and gas prices go up, and it kind of has these psychological, behavioral, economic impacts, as well, on how people react, if they're spending more in their gas tank, et cetera. You mentioned that there was likely to be limited impact on oil. Yet, my thought was that if they shut down the Straits of Hormuz, even though Iran may only produce five percent, doesn't 25 percent of the world's oil go through ...? What's the impact, actually, do you suppose, if oil prices were to spike? How would that impact, again, commercial real estate, and in what way, if at all?
Stuart: Well, Adam, you ask a question where there could be so many ways in which that particular oil price spike could kind of come home, so to speak. There could be a brief disruption, a brief spike, and that could be ... Oh, I see you have a friend there.
Adam: Sorry about that.
Stuart: No worries. No worries. I interrupted myself. Looks like a very nice friend.
Adam: He is a very nice friend. Yeah, I think he wants to go out. He's going to have to wait.
Stuart: We live in a world where the dependency on oil remains, but it is not what it was. There's been some dimension of diversification that should be helpful in a sort of cataclysmic event. We live in a world where there can be increased pumping from the Saudis, or from North America, or from Russia, or from Venezuela, or somewhere else, in the event of cutbacks from the Middle East and the Straits of Hormuz.
We live in a world where, I would imagine, quickly, to the extent that there were attacks in the Straits, there would be rather severe implications for those undertaking those attacks. So, I'm not sure that those attacks, in the form of material attacks, would be ongoing for an extended period of time. They may be perpetrated over a week, or two, or something like that, but there would be implications, certainly, for those attacks.
If it were back in the day- Let's take back in the day ... Back in the day, for your purpose, I believe, in asking this question, is 1973 [crosstalk] is the formation of OPEC - the Organization of Petroleum Exporting Countries [crosstalk] and the formation of an oil cartel, which then jacked up prices by two or three times and resulted in significant gas scarcity; lines outside of gas stations in the United States and around the world, and what we call a cost-side price shock to the U.S. economy, to Japan, and to other major nations around the world.
For example, take Japan. Th OPEC event was extremely costly to Japan. They have no access to petroleum other than through imports. The imports skyrocketed. They brought import-related price inflation. They brought a tightening of monetary policy, higher interest rates, and a slower Japanese economy simply because of the magnitude of the oil price shock. That's kind of the extreme scenario that you're referring to here, and my guess is that we're nothing close to that here, again, like just not even anywhere close.
Stuart: But could there be a week or two of excitement in the Persian Gulf? Without question. Could there be damage on all sides to oil infrastructure production? Without question. Could we, in an extreme case, take out Basra, which is the Iranian oil-producing facility? Without question. What's the issue of Basra? Well, we already have major sanctions on Iranian oil exports. A lot of what they do exporting is absolutely under the table with tankers that bear weird flags and oil that gets transferred at night, below the radar screen, literally.
So, it's not clear. Again, in terms of getting to materiality, here, the example that we gave of an oil price shock that is of sufficient magnitude or durability that it relates to higher interest rates; monetary policy that pertains there, too, that because of higher inflation and, ultimately, slower economic activity, I don't see us being there.