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Chaos Theory: Could A Downturn In London Take Down New York Or Paris?

Someone at the International Monetary Fund has been thinking about chaos theory.

Specifically the butterfly effect, the name for the branch of chaos theory which argues that a butterfly flapping its wings in one part of the world can be the very tiny incident that builds up to a hurricane on the other side of the globe.

In its recent Global Financial Stability Report, entitled A Bumpy Road Ahead, the IMF took this principle and applied it to global housing markets.


Since the financial crash, global housing markets have become more synchronised: prices and the way they move have become more and more correlated, particularly in major gateway cities. A combination of low interest rate policies around the world, improved economic growth and the increasing importance of global capital has caused this alignment. These conditions are even more true in the commercial real estate world, where there are fewer properties and global capital plays an even greater role. 

The problem with this situation, according to the IMF, is that it makes downturns harder to contain — if one market experiences a sharp correction, other correlated markets are likely to experience the same fate, even if local market conditions are different. With housing playing such an important role in modern economies, that greatly increases the level of risk in global financial markets.

A downturn in commercial real estate might not have the same ability to cripple global economies. But how interconnected are the markets of the major global gateway cities like New York, London, Paris, Tokyo and San Francisco? Might a butterfly flapping its wings in Midtown Manhattan herald bad news in London’s West End or La Defense in Paris?

The commercial real estate markets of major cities are far more highly correlated than the residential markets examined by the IMF, especially when prices are rising. The IMF put the correlation of large global residential markets at around 30%, but Real Capital Analytics Senior Director of EMEA Analytics Tom Leahy said pricing in London and New York is about 95% correlated, making them the two most correlated cities in the world. Pricing in Paris and London is only slightly less correlated. Tokyo stands apart — it is less correlated, and has not seen the same price increases since the financial crisis.

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“London and New York are the two largest and most liquid real estate markets, they attract the most capital, and they are the bellwether for where we are in the real estate cycle,” he said.

Data from RCA shows some overlap in the biggest buyers of real estate in gateway cities since 2010, particularly between London and New York. Norway’s sovereign wealth fund was among the 10 largest buyers in London, New York and Paris, and Blackstone made the list in both London and New York. Tokyo was unique in that the list of top buyers was made up entirely of domestic players.

RCA data showed London prices have risen 52% since the end of 2006, New York 44%, Paris 32% and Tokyo prices were flat.

MGR Strategic Consulting Chief Executive Matthew Richardson said this correlation is a result of the increase in global investors chasing the same type of asset, and that it increases the risk of markets in different parts of the world impacting each other in the event of a downturn.

New York skyline

“You’ve got an increasing concentration of capital at the top of the market that is looking for the same thing,” he said. “It is risk averse, looking for low yields and big lot sizes.

“If you look at the way people behave, they like buying things that are similar to what they own in their domestic markets or that they own elsewhere, so they buy the same kind of property across the globe.”

This has been true of many cycles, but globalisation is accelerating in recent years.

“The world is more global today, you have a number of groups who are constantly raising capital and taking a global view on where to deploy it in a way that didn’t happen even as recently as the global financial crisis,” JLL Global Head of Capital Markets Richard Bloxam said. “The largest investors have huge assets under management and so the way they behave is bound to have an impact on markets. And you have a lot of global and regional investors making decisions on a relative value basis.”

That impact could cause pain to ripple around the world.

“In other cycles, at the top of the market everyone piled into secondary assets and lost their shirts,” Richardson said. “This time people went from London, to Paris, to New York or San Francisco, so you have this concentration of the same investors across the world. And if they need to pull their money out of property, they won’t just do it in one market, they will do it everywhere.” 

Richardson added that the risk was increased because of the occupancy profile of the kind of buildings these investors bought. They primarily target properties tenanted by big global financial services and legal services firms, a dip in those sectors could have a broad impact. He also is skeptical of demand drivers these investors have banked on.

“One thing people forget is that as well as increasing asset prices, low interest rates have also kept a massive amount of people in jobs who in another cycle might have been flushed out, which you could argue has created an artificial demand for space.”

Eiffel Tower, Paris

Global gateway cities moving in lockstep could mean cities share each other's victories but not each other's miseries. The global real estate fallout — or rather, the lack of it — from Brexit is a prime example.

"I could see large global macroeconomic or geopolitical events having a more universal impact on real estate investment markets around the world, but an event that is specific to one market such as Brexit on London does not cause a contagion in other global gateway cities," Bloxam said. "Whilst prices certainly moved out in the immediate aftermath of Brexit, long-term owners didn’t budge and markets in Asia and the U.S went on their merry way. It was a specific, isolated impact."

RCA’s Leahy said that in a downturn, gateway markets become less correlated. The firm recently undertook an analysis of liquidity in 155 real estate markets around the globe and found that in the last crash, London retained better liquidity than New York, and pricing did not fall as far as a result. 

“Price movements and liquidity tend to be highly correlated, so investors might want to bear that in mind when looking at where to invest,” he said.

Not everyone buys the chaos theory of commercial real estate, including one of those big global beasts.

"I don’t think it necessarily holds true for residential or commercial," Blackstone Head of European Real Estate James Seppala said. "In residential, portions of the high end market have come off in the last few years in London — driven by a degree of supply — and that is not leading to declines in Paris, Munich or Madrid."

He puts his faith in the tried and true — fundamentals like supply and demand.

"Global capital is obviously supportive to transaction activity, but ultimately values are driven principally by supply and demand fundamentals," Seppala said. "Investor demand in these cities is high because there is stronger job growth, population growth and stronger overall real estate demand and fundamentals in these cities."

The butterfly flapping its wings in New York might not cause a hurricane in London real estate. But with the two markets so closely intertwined, it might pay to keep a weather eye on events outside of your home turf.