The Adventurous Investor gives his take on where we are in the cycle and why UK property investors need to be careful.
In the middle of June AltFi launches its first Alternative Property Forum, featuring most of the biggest and best platforms in this fast-growing niche. There’s plenty to talk about on the day but for me the key questions should all be asked by investors, most notably where are we now in the cycle and which structures should we be investing in as investors?
I have enough grey hairs as a journalist to know that trying to time markets and call turning points is invariably a mug's game but despite this scepticism I can’t quite shake the view that we must be late cycle – we certainly are in other risk assets such as equities as well as bonds. The warning signs are there already. In commercial property, nearly every expert I talk to in the prime office space thinks yields are below average and prices close to record highs. There are pockets of regional value, especially on industrials and some retail, but the consensus within commercial RE is that we can only be 1 or 2 years away from the peak for UK quality, assuming we haven’t already breezed past that point.
Over in residential, the London market has already clearly come off recent highs with many buyers now moving to aggressively cut prices for properties in the £1m plus range, central London bracket. By comparison, there seems to be much more life in cheaper, more family orientated properties in certain geographies – so London isn’t a blow out, just a late cycle redistribution of returns down through the price levels. The regions are also showing huge variations but the core, valuable South East market is definitely showing sings of wear and tear.
There are two very obvious macro economic headwinds impacting property markets. The first is that UK consumer demand is weak, especially after the Beast from the East. Real wages are ticking up, and I think we’ve all collectively become too cynical about the state of the UK economy – but one simply can’t deny that Brexit has had an impact on the wider economy. My hunch is that Q3 and Q4 could look much better, but the damage has already been done.
The other obvious headwind is the prospect of increasing interest rates. My hunch is that the Bank of England is still deeply worried by the UK economy and will keep the pace of increases to a modest level at first but once the economy looks to stabilise in Q3 and Q4 we could see some sharp increases in interest rates. That’ll begin to put some strain on already heavily indebted mortgage customers. I think the US Federal Reserve will quickly get to 3.5 per cent interest rates within 18 months but I also think that we could see rates hit 2.5 per cent in the UK by mid 2019 – assuming of course we don’t have a recession first.
Stacked against this are all the usual long-term capacity constraints, i.e. we’re simply not building enough new properties. Most home builders are close to their maximum capacity and the ranks of smaller family builders have been massively depleted over the last decade. This supply constraint isn’t going away any time soon despite the government’s best efforts (which aren’t actually that great truth be told).
On balance then I think we can begin to paint a scenario where the UK avoids a nasty house price crash but does enter in a slower ‘chilled’ market closer to the German model of the last few decades, i.e. prices don’t really go up very much in real terms outside some regional hotspots.
So, add it all and I would argue that we have a subdued UK residential property market and a late cycle commercial real estate market, with real risks in sectors such as non prime regional retail or prime London resi. I’m not sure whether this in aggregate constitutes the risk of a downturn or just a readjustment, but I think it’s hard to argue with the fact that we must be close to the end of the current cycle – with anything between 6 to 18 months left of possible price improvements at the margins.
If this is the case – and maybe I’m being far too cautious – what should investors be watching out for?
On the equity side of the debate, I think it’s entirely reasonable to be highly cautious about the potential for any major capital gains, outside of a few regional hotspots. Any investment predicated on capital gains looks distinctly questionable to me. By contrast, investors might be looking to increase yields from property portfolios through judicious investments – by changing occupancy structures or maximising rents by upgrading the physical fabric of the building. Investors will also have to factor in the likelihood of increased property financing costs as loans are rolled over in the next year or so.
Perhaps, more ominously, investors also need to think more seriously about risk adjusted returns. I have no doubt that some assets might offer up the potential for 5 or 10 per cent capital uplifts, but the potential of a sharp downturn and losses of 10 to 20 per cent must be growing by the month. So, in risk adjusted returns, are you being offered enough upside potential compared to the increasingly obvious downside risks?
On the lending side of the equation, investors also need to be aware that as interest rates rise, conventional fixed income investments become much more attractive, i.e. more traditional income options become more attractive.
Within the rarefied world of equity funds for instance, we’re already seeing many quality investment trusts offering up income yields of 5 per cent or more. Most investment grade corporate bonds are still priced to perfection, but I wouldn’t be surprised to see running yields on these start to approach 3 to 4 per cent over the next two years as some bonds sell off due to rising rates. If this does happen we’ll see less liquid asset classes such as property debt platforms forced to increase their yields, especially in niches such as bridging for instance – this might have some knock on effects on mortgages as well. Again, lenders will be asking whether their risk adjusted returns are really high enough. If you’re only getting an income return of 3 to 5 per cent in one year but there is a chance of a nasty 5 to 10 per cent loss (from increased defaults), are you really being rewarded for risk?
Which brings me nicely to the capital stack. As you can see, I’m not entirely convinced that I’d want to be too heavily exposed to the equity layer of many property investments – certainly not if I was putting in new cash. I’d want to head up into the capital stack, into the debt portion where there is greater security. Most lending-based platforms won’t lend developers for instance with LTVs of much above 65 to 70 per cent. This implies that even if property prices were to fall sharply – by say 5 to 15 per cent - you’d still (hopefully) preserve your capital. A nasty crunch might impact cash yields but the potential for losses might not be much above say 5 to 10 per cent maximum in one year (from unpaid interest). Personally, I’d also be very keen to understand how lending platforms will react to any downturn, i.e. how actively they’ll manage a loss-making position involving a development for instance. In the past, bank lenders have collectively reacted like lemmings, selling off half finished developments as quickly as possible pushing down prices aggressively. Alternative lenders will need to roll up their sleeves and work out any defaults – and avoid a massed rush for the exits. Lenders will thus need to keep a close eye on not only LTVs but also interest coverage and lending platforms work out policy.
There will of course be huge variations. Some regions look more attractive than others and my only worry is that most lending platforms are too focused on Greater London, if only because that’s where the deal flow is. Maybe some regions will buck the trend aggressively – however, in a big crash, every region will get hammered.
I’d also carefully examine exactly who you are lending to. My gut feeling is that smaller family housebuilders might be a better group to lend to compared with large diversified buy to let landlords. The former is likely to see fairly buoyant pricing on the right kind of new builds, whereas the latter might be more vulnerable to pricing pressures. Over in commercial real estate by contrast, you’d want to be a hundred miles away from most non prime high street residential focusing instead on social housing and industrial warehouse assets.
So, in sum – be careful. Think about where you are in the capital stack and where are you investing in geographic terms. Have realistic expectations for risk adjusted returns. And be on alert for a sudden late cycle surprise!
One last, positive, observation. Despite all my worries about rising rates and bond sell offs, I still think interest rates will remain low over the next few decades – my hunch is that during the next recession we’ll see rates fall back to zero again after their imminent increases.
This means that long dated income options – involving say property debt – could still be attractive if that debt has a long maturity. A well-structured debt package (with a long duration) attached to the right property will benefit from this low rate environment. Crucially a sensible financial structure and duration for a loan will allow the underlying capital value to recover should there be an economic downturn and capital prices fall. So, I’d still be in favour of long income options, with my own bias towards debt within a capital stack.