Are those trying to call the bottom of the real estate market in danger of missing the recovery? David Skinner explains how investors should ‘bridge the trough' of the market by buying selectively
David Skinner is real estate investment
strategy and research director at Aviva Investors
Conditions in real estate markets, as with other asset classes, remain difficult and 2009 is likely to prove to be another challenging year for property investors, with values under pressure in all major markets.
Valuation declines have become geographically widespread and the pace of decline has accelerated in the months up to year-end. The driving forces behind the declines remain tightened credit conditions, turbulence in global financial markets, increased investor and lender risk-aversion and growing concerns over the economic outlook.
These forces continue to severely limit the number of able and willing buyers for real estate assets, and transaction levels remain very low. Unsurprisingly, given the global nature of the current financial market turbulence, these trends are common to all major international real estate markets. According to Real Capital Analytics1, global transaction volumes were down almost 60% in 2008, relative to the previous year, with the fourth quarter decline particularly marked.
Given these dynamics, stabilisation in real estate values is likely to require movement in a number of key inter-related variables.
- There must be greater visibility on the economic outlook. To date, the greater part of the decline in values has been driven by yield shift, but with economic activity slowing very sharply, occupier market weakness is expected to become a much more significant driver of valuation falls.
Globally, there has been a very pronounced weakening of economic activity indicators since the collapse of Lehman Brothers. Many such indicators have fallen to their lowest levels in decades and the global economy is facing synchronised slowdown with recession likely in most developed economies, despite fiscal and monetary policy measures being employed increasingly aggressively;
- Credit conditions, most notably availability of credit, need to improve significantly. The cost of credit to those who can get it is falling with the very aggressive rate cuts being enacted by central banks. Libor and swap rates have declined significantly, and even though lenders' margins (and other fees) continue to expand, the overall cost of debt is declining. However, ongoing bank de-leveraging means that credit availability remains very limited and surveys of lending conditions in the major economies suggest that banks intend to tighten lending further;
- Prices of other asset classes must recover. While direct real estate is looking better value relative to the conventional comparators such as cash, long-term government bonds and the cost of finance, values remain stretched relative to assets such as equities, corporate bonds and commercial mortgage-backed securities (CMBS). The case of real estate in asset allocation decisions would likely be very much enhanced by falling corporate bond spreads, an increase in the supply of corporate bonds and a fall in the equity risk premium. If these can be established, together with an increase in the availability of bank finance, expectations of growth and earnings will improve;
- Real estate valuations have to look fundamentally cheap. With values continuing to fall many investors will be looking for better than fair value before increasing their exposure to the asset class.
To the extent that progress on the first three of these variables will be relatively limited in the near-term, my view is that property values will fall significantly further in all regions during the course of this year. Though fiscal and monetary policy measures are expected to succeed in reviving the global economy, this will not be before the second half of the year at best and the following recovery is likely to be muted.
Credit availability is likely to remain very limited and subject to further government measures to assist in strengthening bank balance sheets. In the meantime, the valuation case for real estate strengthens.
However, investors waiting for evidence of a turning point in the valuation cycle before recommencing acquisition programmes will likely miss the excellent (if not unprecedented) opportunities that will emerge during the course of this year. In some of the markets, where the correction has been fastest and most marked, valuations already look to have overshot fair value and opportunities have begun to emerge.
The most prominent example of this is the UK market where capital values had fallen by an average of 35% by the end of last year from the June 2007 peak, and initial yields had risen to over 7%, according to Investment Property Databank (IPD)2. As an aside, we believe the required return on UK real estate to be somewhere in the region of 7%; given an initial yield of 7%, it's easy to get there without heroic assumptions on income growth, depreciation and transaction costs.
Buying UK real estate off these numbers is certainly attractive by both historical standards and relative to its conventional comparators. However, the major opportunity comes from the fact that those investors able to commit capital to the asset class today are able acquire from stressed or distressed vendors at prices considerably below valuation.
Not only are these transactions priced at levels which imply a very bleak economic outlook and little improvement in credit conditions over the medium-term, they are also priced attractively relative to other asset classes such as corporate bonds and CMBS. While the ability to pick up assets at heavily discounted prices both in the UK and elsewhere is likely to become more widespread, as an increasing number of stressed and distressed sellers emerge, the window of opportunity is expected to be narrow.
The number of active buyers is limited currently, of course, and so are those able to fully exploit the stress that prevails. There are, however, a number of well-capitalised investors on the sidelines biding their time.
Among these are the opportunity funds that raised very large volumes of equity in 2005 and 2006 (although the purchasing power of some of these will likely prove lower than initially envisaged given credit constraints), pension funds and private investors for whom the case for real estate in asset allocation decisions is building.
As these investors enter the market, competition for assets will materialise and the spread between valuations and transaction pricing is likely to disappear quickly - and long before valuations begin to recover towards fair value.
Timing the bottom of the market is exceptionally difficult. Buying in at the trough in valuations is not an optimal strategy, as investors will miss out on the ability to exploit the divergence between transaction pricing and valuations that prevails in some markets now and which will become more apparent during the course of this year as distress becomes more widespread. Instead, investors looking to increase exposure to real estate should aim to buy selectively through the bottom of the cycle, bridging the trough.
As more investors recognise this we believe transaction volumes will pick up and confidence will return sooner than would otherwise be the case.
1 Real Capital Analytics, Global Currents, January 2008
2 IPD Monthly Index December 2008