The deluge and constant reporting of CRE woes is understandable, but seems over-hyped relative to some other potentially bigger problems brewing. Compared to most asset classes, real estate is funded by a higher proportion of debt, and with the good old days of free money gone for the foreseeable future, repricing to higher funding/discount rates has been necessary.
However, the repricing has been somewhat uneven; in the UK has been marked down anywhere between -5% and -25% as reported by REITs. The shares of REITs are on average down by a lot more – 35-40% – which, backing out the effect of leverage, implies a 25% drop in gross asset value since their recent peaks in 2021. Said differently, there’s plenty more bad news priced in listed REITs than private real estate values. In such circumstance, REITs outperform private market returns.
The sentiment around both private and public real estate is close to the levels of the Dot Com era and GFC. When sentiment is this low relative to broader equity markets, REITs tend to also outperform broad stock indices on a relative basis, especially if we are close to peak interest rates, inflation, and can avoid a hard landing as most now seem to believe.
While the repricing has been painful for investors, it is rational; values need to reset lower to deliver the higher prospective returns in a world where “risk free” government bonds are delivering 4-5% and there is ~200-300bps risk premium on unlevered real estate to deliver total returns of 6-8% depending on the sub-sector.
One saving grace is that the real estate market can operate on lags. Leases and debt both have relatively long unexpired terms; this is especially true of non-private equity structures which use mostly equity financing and often fix/hedge interest rate exposure. This group can ride out market gyrations to some extent.
The same is not generally true at the smaller scale of family offices or wealthy individual investors; their ability to access capital and manage through cycles is lower on average because of assets they own, their high leverage, and mixed banking relationships. Much of the regional bank exposure that we read about appears to be with this group, so if the expectation of goldilocks conditions does not materialize, then further pain can be expected. The silver lining is that, relative to the GFC, securitization/derivatives are not many multiples of the value of underlying assets they represent.
So, where are the bigger problems that don’t make the same types of headlines?
To answer this, let’s think about when parents buy their kid’s school uniform; it’s often one or even two sizes too big. At two sizes, your child is likely to get picked on, but for some that’s worth the risk if they can’t afford it. On the other side, you let them outgrow a little, especially if summer holidays/new school is to follow shortly. Where parents – and kids – draw the line is when they intuitively observe growth slowing in late adolescence.
For the brightest financial minds, the above should be entirely obvious in relation to accounting for the maturity profile of businesses and their valuations. Granted, mistakes can happen in either direction – whether people or businesses – but on average, any individual under/over estimation should be cancelled out.
This process in the financial market appears to be working less well, averages do not even out in an efficient manner. On an individual basis, large price movements seem to be happening to behemoths in the technology space. This is not new. Price movements were even more exaggerated in the late-90’s Dot Com era, 1980’s Japanese stock market and real estate bubble, and others before that. There are many narratives that try to rationalise why it’s different this time, primarily:
- Total dominance of large tech.
- Strong profit generating capabilities.
- Superior growth rates.
For a moment, let’s go with the flow…
Using consensus estimates from Visible Alpha, we extend the investment horizon to 2050, and apply generous assumptions. We take the Magnificent Seven (Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta, and Tesla) and note that of the $32.1 trillion starting S&P500 value, they made up ~21% at the beginning of 2023. As of writing in early-August, the S&P500 has risen to nearly $37.7 trillion (+18%), but the value of the Magnificent Seven has risen from $6.9 to $11.1 trillion year-to-date (+61%). So, 75% of all the increase in the S&P500 came from the Magnificent Seven; this is known as low market breadth.
That is a remarkable achievement! However, it’s nothing compared to what they need to achieve to deliver a 10% annualized return by 2050. Remember, these are the 100 or 1000-baggers, so 10% annualized return would be significantly lower than their historic performance. It is also what we need as risk-free rates edge higher towards 5%, and the equity risk premium is another 5% on top.
To get to a 10% IRR at today’s valuation, you need to assume the Magnificent Seven revenues grow annually at 10% (15% for Nvidia and Tesla), the Free Cash Flow Margins are improving and stay higher than historic levels, and the payout ratio of dividends/FCF is tripled. With these heroic assumptions, the current revenues go from 1.4% of Global GDP to ~13% (using 2050 GDP estimates by OECD). Thereby, each company is not just an industry leader; they are likely to each be the majority of their industry. In terms of valuations, they go from $11 to $126 trillion by 2050. All this just to get to a 10% IRR.
The $11 trillion valuation is a problem, because resetting the Magnificent Seven to levels where you don’t need heroic assumptions to get to a very reasonable 10% IRR would be disastrous for the wealth effect and trickle-down economics. But the Magnificent Seven are not to be singled out, as there is a wider equity market valuation problem where over 100 large-cap companies trade at >10X revenue multiple. Collectively, we’re buying clothes that are multiple sizes too big for late adolescents!
A quote from Scott McNealy, CEO of Sun Microsystems, sums up the problems with 10X revenue multiples shortly after his company and the wider stock market fell back to Earth:
“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any
footnotes. What were you thinking?”
Hindsight is wonderful, but not always necessary. What are we thinking?
As an investor I have plenty of worries; CRE is not high on the list, except in cases where it’s not been marked down, and leverage is too high. Large parts of the market – in particular, the public REITs – are, on average, well positioned to outperform on a relative basis. What I worry about most is egregious and unaffordable government budget deficits that keep swelling just to keep the wheels turning, and the head-scratching mega-cap US equities that need a bigger petri dish than planet earth to justify their valuations. Some banks are too big to fail; Magnificent Seven are too big to fall.
