Originally published April 2023.
In one of financial history’s key observations, Howard Marks warns, “we must never forget about the inevitability of cycles. Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do.”
Unfortunately, J. K. Galbraith observed that “there can be few fields of human endeavor in which history counts for so little as in the world of finance.”
When markets deliver growth for many years, investors believe the good times can last forever. So, major inflection points come as a shock and a challenge to their understanding of markets.
We are living through one such inflection today, and many investors are struggling to grapple with new market realities.
Fortunately, for those willing to engage with the history of property cycles, there are lessons to uncover. The past can be a guide. Remember the Mark Twain adage, “history doesn’t repeat itself, but it does rhyme.”
Here are five lessons from previous real estate cycles relevant to today’s portfolio positioning and asset selection.
1. Don’t panic
Real estate may be cyclical, but it is also resilient.
Good quality real estate generates stable cash flows. History has shown that a diversified portfolio of standing assets usually delivers a relatively consistent income, even during a downturn.
Generally, the need for real estate stays robust when growth stalls. People still need places to sleep, work, meet friends, store their goods, see doctors, get a haircut, and do many other activities.
Remember that the economic environment changes, financial conditions evolve, and property values oscillate around a long-term upward trajectory. We should expect volatility. A downturn should prompt tactical adaptions, not significant strategic changes.
2. Start in a defensive mode
While income returns are typically resilient, capital values do fluctuate. The price an investor is willing to pay for a property reflects the present value of the future cash flows they believe the asset will generate.
When their cost of capital changes, investors will apply a different discount rate to future cash flows, and the price they are willing to pay will change accordingly. Higher interest rates explain much of the recent repricing in real estate markets.
The price investors are willing to pay for an asset will also change if they judge there to be more downside risk to future cash flows. For example, some companies may become insolvent in a recessionary environment, and many may seek to reduce property costs.
Valuations of less risky real estate assets generally prove more resilient in such a scenario. The fewer risks to income, the better. So in a downturn, it is better to have exposure to the following:
- Fully leased properties rather than vacant or partially vacant properties
- Assets with longer rather than shorter leases
- Properties leased to strong, well-capitalized businesses to reduce default risk
- Desirable, high-quality assets in established locations with a depth to tenant demand (so leasing or releasing a property should be achievable without significant rental discounts).
Selecting assets that boost the resilience of your portfolio’s income will limit the degree of capital value declines you are likely to experience.
3. Think long term
A vital attribute of a successful long-term investor is distinguishing between structural and cyclical drivers of property performance.
It can be much easier to believe that you have identified the correct thematic drivers when the value of your portfolio is increasing.
A decline in values may give pause for thought. But if the fall is driven purely by cyclical factors, it should not necessitate a reassessment of strategic and thematic thinking.
Suppose you had an investment thesis around self-storage in thriving urban areas, urban logistics in supply-constrained markets, or specialist residential solutions for tomorrow’s demographics. In that case, a downturn and recession should not challenge your underlying strategy. Indeed, repricing may provide a more attractive entry point to execute on long-term strategy.
Those that retain a long-term approach should be able to capitalize when others lose conviction in their understanding of structural drivers.
4. Position for mispricing
During an economic downturn and a period of tightening financial conditions, stress emerges somewhere in the financial system. It is impossible to forecast where and when, but it is probable that at some point, someone will find themselves in the unenviable position of needing liquidity fast.
Be ready. Distressed sellers will generate attractive opportunities for those with capital, a long-term mindset, and the ability to hold their nerve and invest against an unstable backdrop.
Even risky real estate assets could become attractive in such a scenario. Remember the observation of Howard Marks that “there are few assets so bad that they can’t be a good investment when bought cheap enough.”
5. When stabilization is in sight, take on risk
As the cycle evolves, so will investors’ emotions. If today’s investors are experiencing anxiety, they may feel fear, panic, and even despondency in the quarters ahead.
Investors’ emotions guide their actions, often more than they should.
In hindsight, excessive excitement and optimism may have meant that at the cycle’s peak, some investors were too willing to underwrite transactions based on a prolonged period of low interest rates and strong rental growth. In doing so, they committed the cardinal investing sin of forgetting about the inevitability of cycles.
But here is the thing: history suggests that the same will happen at the bottom of the cycle. Investors get too beat up to believe a recovery will come. But guess what – to date, recovery has followed every downturn.
When the downturn is well-advanced and the cycle appears near a trough, it is time to increase your risk appetite. After all, investors’ emotions mean that prices fluctuate more than long-term fundamentals justify.
Putting these lessons into practice
Some of these lessons may feel challenging to put into practice. It is hard not to panic when prices are falling quickly. It is tough to have the courage to act with pace when others are stressed. It often feels uncomfortable to act in a manner contrarian to the majority.
That is why Warren Buffet said, “investing is simple, but not easy.” And it is why Robert Arnott stated, “in investing, what is comfortable is rarely profitable.”
Positioning portfolios in a cyclically-aware fashion feels difficult. But history shows that superior long-term investment performance is achievable for those that embrace it.
