As they cast their nets for opportunities real estate investors must take note of the broader economic threat that might throw them off course and leave them badly damaged, as José Luis Pellicer reports
After the most devastating hurricane in the lifetime of most fishermen, the village harbour now looks broadly calm. Catches are good and things are slowly getting back to normal. Yet, some clouds are now appearing on the horizon - a cold front is rapidly approaching the shore and fishermen are bracing themselves for a possible storm, albeit not as devastating as last year's.
This is the world financial sector at work. A sovereign default (were it to happen) would, indeed, be a fatal event - government stops paying civil servants and pensioners and, consequently, consumption and investment collapse. Sometimes even the banking system closes down altogether and no-one is able to get hold of their savings (as happened in Argentina in 2001). Sovereign bond holders (often international banks and insurance companies) see the value of their assets wiped out as the fears of default increase. A crisis of confidence quickly follows that can easily spread into massive fire sales and currency devaluations. This creates further asset write-downs as investors try to exit that country's assets. In fact, any asset denominated in that currency is bound to suffer. This can, therefore, easily create a collapse in equities as well (as happened in Russia in 1998 and Brazil in 1999). It is not surprising that the EU has put together a bailout package for the weakest countries to mitigate risks.
Broadly speaking, investors appear to have been moving away from risky assets - equities, high yield corporate bonds and commodities - and moving into safer government bonds or some AAA corporate bonds.
Like fishing boats after a storm, the banks are undergoing major repair and despite the recent successful ‘catches', those that set sail are not in optimal condition to weather the new storm. If the storm does come, fishermen will have to wait for calm before setting sail again.
The banks - the engines of the system - have enjoyed juicy profits in 2009/10 but are still cleaning up their balance sheets and are now somewhat concerned about further write-downs from Greek and Spanish government debt (much of which is in international hands). European banks have toughened their lending criteria somewhat and loan books remain broadly flat - the outstanding notional of corporate loans to non-financial corporations has been falling since 2008 - while notional of consumer credit has barely moved since 2007. Mortgage lending, however, has enjoyed some expansion in the euro-zone since mid-2009 although this appears to be easing. Mortgage lending in the UK, however, has suffered a structural change and is now back to more cautious pre-2000s levels, with LTV ratios for first-time buyers moving from 90% to 75%.
Meanwhile, commercial real estate investors are still looking for opportunities, like deep-water fishermen who go about their work unconcerned by the clouds overhead. They trawl the deep sea in search of greater yields. They are firmly focused on the treasures on the sea bed, and often disregard the sky above - their approach is a ‘bottom-up' one. Now, these fishermen are not really looking at the storm, some even claim that this is a phenomenon of the sky that is not affecting them in deep waters - they are in a different business.
These are commercial real estate investors. Some have a tendency to focus on their spending targets and the specific risks of the assets they buy and manage, unconcerned by what is happening in other asset classes or the global economy. Commercial real estate seems to be defying its times - particularly in continental Europe. Jones Lang LaSalle (JLL) figures suggest that the investor market is even heating up, with prime office yields having heavily compressed in many cities. This is not the sort of ‘credit boom heat', where prime Paris and London office yields fell to sub 4% at one point in 2007, but 4.5% in London West End appears overheated to us in view of a bleak economic outlook for the next two years. Another example is Central Europe.
But just as any good deep-sea fisherman knows that a storm creates waves that also affect the ocean floor, direct real estate investors should be aware that the macroeconomy and government finances also affect individual properties' returns. And just as a deep-sea fisherman can get pulled off-course without knowing it, so the real estate investor can get hit by a subdued investment market. Indeed, like other fishermen that use different fishing methods, REIT investors, with REIT prices falling, are now bracing themselves after a massive ‘catch' last year. REITs enjoyed substantial returns in 2009 but they have remained stagnant for the whole of 2010. UK REITs act as a leading indicator for direct property returns. Not so in continental Europe, where either large REITs are internationally diversified or the national index is not well developed or the REIT sector is not well developed). In any case, REIT return series indicate that direct real estate total returns should stagnate in the UK in the short term, as do property derivatives - implied capital growth for 2011 is broadly -5%.
The general economic trend is also one of slow growth for some time to come - not a new credit crunch or a "W", but not a "square root" either. In this context, investing in value added real estate should be counterproductive. Low risk, high income, long leases, low rents and solvent tenants are probably the best strategy (if the price is not too overheated). Go regional if needed, but do not compromise on income, occupancy or reversionary potential. The storm will not be blowing with the same strength throughout the world.
So we get to the moral of the story: a simple one - look at the signals from the sky, whether you are a shallow-water fisherman or a deep-sea trawler that is only concerned with the ocean's depths. Right now, the signals point towards cautious investing rather than risk taking.