Frank Gelber says the aberration was the financial engineering boom, not the financial crisis bust. Here is his chronicle of the wages of greed.
Most commentators focus on the impact of the “financial crisis” on markets and on the economy, forgetting that it was the excesses of the preceding boom that are being unwound. It’s not the financial crisis that was the aberration. It was the sheer magnitude of the preceding financial engineering-driven boom. And that happened both here and overseas. Let’s focus on Australia. And my focus is on commercial property. The boom was insidious. A gradual build-up of the inflow of funds saw a steady firming of yields and sustained capital growth through a five-year period. It’s easier to see now, after the fact, how far prices over-shot. But it was more difficult at the time.
It was all driven by greed, of course. Investors, seeking that little extra return, went from fixed interest to mortgage-backed securities, from direct investment to derivatives, from ungeared to geared investment. In the property markets, the logic of financial engineering (FE) was pervasive. Get a secure cash flow and gear it up to improve the return on equity. At first, we didn’t care about capital growth – we just needed cash positive investments. But the strong inflow of funds caused a firming of yields, giving us the windfall gain of capital growth as a bonus. By this time, financial engineering was big business and had gained momentum. And people had come to expect continued firming of yields – they called it “yield compression” – and the name somehow justified it and gave it the status of a law of finance. Don’t you just love it when we put a name to a phenomenon with the status of a law of behaviour. I’m immediately suspicious that’s something between marketing and wishful thinking.
When the inflow of funds caused yields to firm to levels below interest costs, we needed the capital growth as well to make the logic work. And for a while, continued inflow of funds achieved that continued firming of yields. But it couldn’t be sustained forever. The expansion of the financial engineering business into cash-negative territory had sowed the seed of its own destruction. All the while, the whole process was biased towards higher-yielding, “yield accretive” investments. There’s another name, giving spurious credence to a course of action. Conveniently forgetting that the higher yields were traditionally a reflection of higher risk, they geared up the returns anyway – to improve the return on equity. “We don’t want those old-fashioned property investments. We just want the cashflow.” Not only did we see the substantial inflow of funds cause yield compression, but higher- yielding investments experienced much stronger firming of yields than lower-yielding investments.
The flow of funds caused a compression of relative yields. With equity and debt finance readily available, we ran out of suitable investment property in Australia and had to go overseas to satisfy investor demand. We all know what happened next. The global financial crisis triggered a switch from greed to fear in both debt and equity markets, pulling the rug out from under the gearing logic. It affected both highly geared and less geared operations, with forced sales causing a correction in property values. It quickly turned the highly geared financial engineers into negative equity territory. But it also is causing great difficulty for more moderately geared players. And here we are in the middle of the fallout from the financial crisis, focusing on survival. For those caught, there’s no choice. Indeed, the major players – the real estate investment trusts (REITs) – have been hamstrung for lack of finance. Certainly, we need to understand how this plays out.
But by focusing on the downturn, we lose sight of what the world looks like once the financial crisis has receded. And it will. At BIS Shrapnel, our research efforts are focused on forecasting rents, prices and prospective returns in the post-crisis world. Firstly, the investment market. There is no doubt that the FE boom caused an overreaction of property prices. Yields were far too low at the end – we won’t see them at anything like those levels for at least another decade. Interestingly, when we started to test whether the financial crisis caused an aberration, we discovered that in terms of past behaviour of yields it was the FE boom that was the aberration. The financial crisis had triggered a correction back towards sustainable levels. That correction is not over. There are more price falls to come as yields soften further. Secondly, the leasing market has only just begun to weaken.
The economic downturn will continue through another year at least as the fall in business investment impacts on economic growth and jobs, and on the demand for property. Rents will fall, underwriting further falls in property values over the next 18 months. But development has collapsed – for lack of finance, for lack of financial feasibility and for lack of purchaser of the completed building. And we’re not likely to see much speculative development in the next round. That means we’ll need pre-commitments at rents sufficient to underwrite financial feasibility before we can build again. Already, prices are well below replacement cost levels. So we couldn’t develop even if we could get the finance or the end purchaser, and now we can’t. For me, replacement cost is a benchmark for property prices. Certainly, other things equal, with yields now higher, rents will have to be higher to underwrite financial feasibility.
Fluctuations in construction and site costs will also play a role. (That’s a warning to those who wear the hat of fulfilling leasing requirements – the next 18 months present a window of opportunity to lock in a low cost structure for the next decade.) After the next 18 months of weakness, we expect the economy to recover strongly in 2011 and subsequently. That will underwrite strong demand which, given the low supply, will quickly absorb excess stock, driving a recovery in rents. Prospects vary sector by sector. But for some sectors we can already see the light at the end of the tunnel within a five-year horizon. The property world will look quite different in five years’ time. There are traps. But for property investors, this is a time of great opportunity. The key to property investment is to buy well. We couldn’t buy during the boom. But many are afraid to buy in the bust. Most investors now are focused on risk.
Actually, if we measured risk by historical variance, as in the modern portfolio theory, recent falls in prices would result in an increase in measured risk. For me the logic is the opposite. Using historical mean and variance to drive the modern portfolio theory optimiser is a recipe for shutting the door after the horses have bolted. For me, the risk was high in the boom. But the fall in prices, now significantly below replacement cost levels, has reduced risk. This market won’t recover quickly. We expect a weakening in the leasing market and further falls in property values over the rest of this year and next. But the downturn won’t last forever. Meanwhile, it’s a patchy market, with some deals anticipating price falls, and valuations lagging.
We do a calculation based on our forecasts of commercial rents, yields and values. Our estimate of the internal rate of return on a five-year investment in Sydney or Melbourne commercial property made in December 2010 is between 18 and 20 per cent. Retail doesn’t look too bad either. That’s extraordinary. The weakness of the next 18 months presents an extraordinary opportunity to set up strong returns three and four years hence. Prices are already well below replacement cost and, given little speculative construction in the next upswing, they’ll overshoot replacement cost. This is not the time to sit on our hands. This is a time of opportunity for investors. But there are traps. Proceed carefully – but proceed.