Now is not the time to be avoiding risk in property markets. But, warns Frank Gelber, not all property markets.
Post GFC, everyone has gone risk averse. Not only did that trigger the magnitude of the downturn, but the market remains excessively focused on risk. I regard that as an anomaly. To me, most of the property risk has gone. The current market is low risk, not high risk.
Some people think that high prospective returns mean high risk. Not necessarily! Excessive focus on risk has cleaned out overvaluation, cut new supply and set up strong returns in the forthcoming upswing. Indeed, I regard current investment in property as high return/low risk. The correction has taken most of the risk away. Let me explain.
Unlike overseas, in Australia we didn’t have a financial crisis. Here, weight of money from the financial engineering boom had led to overvalued property markets, but we didn’t have oversupplied property markets. Hence the GFC triggered a correction in property prices and curtailed investment through a credit squeeze and an equity squeeze without causing a financial crisis.
I’m not just talking about lenders. Equity investors, too, ran for cover, taking the hit from falling property prices and limiting further exposure. Certainly, given the inability of listed property trusts (LPTs) to sell property assets, the reduction in gearing required injections of equity. But, with respect to major allocation of new funds, investors are waiting on the sidelines to see how things pan out.
And now the regulators are busy trying to ensure that the same thing doesn’t happen again. It won’t – at least not in the same form and not quickly. They’re wasting their time and our money. The overconfidence and excessive gearing that set us up for the GFC has gone – we’re much more cautious now and it will be a long time before we go over the top again. Moreover, we won’t make the same mistakes again – they’ll be (slightly) different next time. And it’s that next episode that we want to prevent.
Why are regulators still so focused on risk? To me, most of the risk has gone. To me, risk is not just high variance. Some look at risk purely as statistical variation without trying to understand where it comes from. That’s not good enough. The danger is that the statistical approach lumps uncertainty associated with knowable outcomes together with unknowable risks – and hence overstates risk.
And measuring risk is even more fraught. I don’t mind using maximisers. But I do object to using historical mean and variance of returns. That’s lazy. It’s a recipe for shutting the door after the horse has bolted and locking it so that the horse can’t get back in again. It’s a recipe for buying as the market approaches a peak, and selling when the market has fallen. That’s a dreadful investment strategy.
What we really need to use to identify the investment frontier and drive allocation is expected return and estimated variance of expected returns.
I’m a forecaster. I look at the future in terms of outcomes and probabilities, always trying to specify what course of events will lead to different outcomes. In looking at risk, I’m more concerned about adverse outcomes, be it to lenders or investors. And there are many types of risk associated with different outcomes, some unforeseen but others foreseeable. In the statistical approach they’re all lumped together. For me, the objective is to identify as many specific risks as possible and to understand how these risks vary through time and circumstance.
How does this relate to property now? Let’s focus on three specific sources of risk.
In the financial engineering (FE) boom, which preceded the GFC, the gearing up of equity for property, together with further inflows of equity, caused prices to overshoot. Sheer weight of money for existing assets drove yields too low. However, the GFC-triggered correction in yields and prices has taken away the risk associated with overvaluation of property.
Indeed, lower yields mean that the rent required to underwrite financial feasibility of new projects has risen, leaving prices in many property markets below replacement cost levels. Prices are too low. And that means that, as leasing markets tighten, the next correction is upwards. The risk of price falls is low.
Further, excessive gearing is a risk in itself. And during the FE boom, gearing became excessive. Again, the GFC-triggered reduction in gearing, largely through increased equity, has reduced risk.
During the financial engineering boom, I was concerned about overbuilding causing oversupply, significant falls in rents and prices, and a collapse in many of the office markets. Now, with the collapse of new development associated with the GFC credit squeeze, the risk of overbuilding has gone. To the contrary, we’re now underbuilding and facing the prospect of a shortage of stock driving strong rises in rents and prices. The risk of a cyclical decline is minimal.
In the statistical approach, the correction would indicate lower returns and higher risk than before. Certainly, measured mean returns have fallen and variance has blown out as a result of the recent decline. But, again, the horse has bolted.
The correction has removed the major sources of risk. The risk of a cyclical decline has fallen, not risen. Indeed, now the “risk” is on the up side. To me, expected returns are higher, not lower, than before the correction. And downside risks are lower, not higher, than before the correction.
Having said that, we won’t see a massive inflow of investment funds driving yields. Investors are much more cautious now. Rather, the next upswing will come from strength in leasing markets driving rents and hence property values; slowly initially, but then picking up momentum as the upswing proceeds. Only then will investor confidence and a strong inflow of equity funds lead to firming yields. The correction in prices and the overreaction on the supply side has, in some markets, set up the preconditions for a build-up of momentum into what will become a boom three to five years hence.
A quick warning. My comments aren’t uniform across markets. Prospects for different markets are quite different.
– The residential recovery has already begun and will build up momentum into what will become a boom over the next three to four years, before rising interest rates curtail the upswing.
– In retail, the correction was in prices, but cash flow remained stable. Retail will show solid returns.
– Industrial property prices will improve as higher yields require higher rents to get back to replacement cost levels, but an oversupply of industrial land will contain returns.
– My pick of investments is office property, where rents and prices need to rise significantly just to get back to replacement cost levels. Indeed, we expect a shortage of space to cause them to overshoot, underwriting the next boom. Sydney, Melbourne and Adelaide will recover first. Brisbane, Perth and Canberra still face weak markets for a few years before they can absorb oversupply.
In BIS Shrapnel’s latest forecasts, we’re looking at internal rates of return of up to 20 per cent in some markets. To me, this is an opportunity to get into what I regard as mis-priced markets.
This is an extraordinary time.
Forget the statistical approach to risk. And whatever you do, don’t let the historical mean and variance of returns drive your estimate of the investment frontier and your allocation. You can’t drive either safely or well by looking in the rear vision mirror.
I’m looking at high expected returns and low risk of adverse outcomes. I’m tactical rather than strategic in my investment approach, both in investment and lending strategy. And I’m really aggressive about shifting my allocation towards property investment on both a defensive and a maximum return logic.
Dr Frank Gelber is director and chief economist of BIS Shrapnel