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The investor’s conundrum.

The first quarter of the 21st century has been a rough ride for financial markets and consequently for the investors that they serve. Is there any good reason to expect the rest of the century to be any smoother?

Not so long ago, a claim could credibly be made that “Real Estate Comes of Age”, together with a suggestion that “the commercial real estate risk premium will remain below its historical average”. This was in 2007, just ahead of the GFC, throwing a sharp spotlight on the real estate sector.

One response to the GFC has been to advocate on increasing transparency and expanded data collection in financial markets, especially real estate debt finance. Examples of this are the IMF sponsored “G20 Data Gaps Initiative”, launched in 2009. Another is the UK “Vision” report which reflected on “the long tradition of financial crises linked to the property cycle”, one every 20 years on average over the past century.

Among other proposals the “Vision” report recommended that: “all lenders in the UK commercial real estate (CRE) market […] should be required to collect and submit to a centralised database specified information about each UK CRE loan.”

Backed up by more data, policy recommendations are often constructed around monitoring the market divergences from identified long-term benchmarks such as risk premia to sovereign bond rates or credit growth.

But, as an illustration of the challenges, consider this from a Nobel laureate economist, published one month after the “Vision” report:

“…attempts to reform credit markets in the wake of the recent financial crisis often draw on insights grounded in our understanding of stock markets. This can be very misleading […] opacity often enhances liquidity in credit markets…”

The pandemic, though not of the same scale as the GFC, has left a legacy of conundrums around long-term benchmark. These shifts in valuation metrics are a response to real changes in the working, shopping and inventory habits of households, workers and businesses.

Shifting benchmarks

With the post-pandemic resurgence of consumer price inflation and resulting sharp rises in policy interest by central banks in many developed economies, attention is clearly now focused on long-term value benchmarks to which broadly defined financial, and real estate markets, can be expected to revert with reasonable alacrity once “normal” conditions return.

It is not hard to find benchmark divergences in current markets. For example, the CRE risk premium in Australia, defined here as the spread between CRE reported discount rates and the government 10-year bond rate is close to a 30-year low (Figure 1).

Figure 1: Australia Commercial Real Estate/10-year Bond Rate Spread

However, reversion of real estate valuations to long-term benchmarks should be scrutinised with some caution. A member of the Bank of England Monetary Policy Committee for example has suggested discouragingly that: “There is […] no ‘normal’ level of interest rates.”

Indeed, the further back we go, the less does reversion to recent cyclical means seem guaranteed. Real interest rates have been in a decline for 800 years and indeed the trend line published in a Bank of England Working Paper chart pointed to the arrival of interest rates at the zero lower bound (ZLB) just as they moved the Bank Rate down to an all-time low of 0.5% in 2020 (Figure 2).

Figure 2: Global Real Interest Rate and Trend Decline (1311–2018)

Acknowledging that real estate is a long-term investment, it might be argued that the Plantagenet and Tudor dynasties provide a problematic basis for office or retail mall valuations in the 21st century. But Figure 2 does highlight how unusual the steady decline has been in real interest rates since the early 1980s until 2020.

Has this helpful trend now come to a stop?

Not to accentuate the negative, there are signs of a shift of emphasis in the way in which we view real estate finance and investment strategies. Recent financial shocks have spawned some thoughtful insights.

One insight is that the concept of some continuum from senior debt to equity, with instruments such as mezzanine debt located along on the upward sloping line, provides at best a partial insight into the capital stack. Debt and equity are more than different contractual claims to a collection of physical assets. They perform fundamentally differently in a volatile environment.

In the case of debt, “financial markets can remain calm in the face of large imbalances until suddenly, one day, they no longer are”6. In the case of equity, “returns are typically high when the economy is doing well, and low when the economy does badly. That is, equities pay off least when households need it most”.

That, perhaps, is the reason why the rewards from long term equity investment are so high. As a further insight, it has been suggested that public debt is the main transmitter and private equity is the most significant receiver of shocks. So for investors, even more than for proprietors, debt and equity are far from perfect substitutes.

Right now, recuperating from the GFC and pandemic, we are challenged to discern long-term value as we disentangle falling headline inflation, volatile interest rates supported by artfully ambiguous statements from central bankers, and in some CRE markets, wide divergences between public (REIT) and private valuations.

Some tentative conclusions

• The major shocks to real estate markets emerge from outside the sector. Therefore, an investment strategy focused on real estate market metrics will lead to many surprises.

• Portfolio diversification across locations, sectors or financial instruments offers potential risk mitigation and perhaps enhanced returns, except in the case of major shocks, and a suggestion that post-GFC portfolio diversification benefits are now less than previous.

• We seem to be at the end of a forty-year decline in nominal and real long-term interest rates; a 30-year period of stability in relative values across the major CRE sub-sectors; 20 years or longer of sub-5% inflation in many advanced economies.

These multi-decade trends cannot be guaranteed in the future, and a quick return to “normal” market conditions is problematic. A checklist of permanent shifts and transient anomalies to set alongside familiar long-term benchmarks, may be an aid to reducing the complexities of the current property market.