Frank Gelber says that now is the time to be brave when it comes to advising on commercial property.
Superannuation funds will come back to direct commercial property investment…eventually. As will the rest of the investment community. And that’s sensible. I view commercial, and in particular office, property as a low risk/high return investment.
But they’ll be slow to come back. Too slow. By the time they pluck up the courage to return, they’ll have missed the best opportunities.
And it’s not just the super funds. Individual investors and their advisers, too, are super-cautious after the bust. The irony is that this is a low-risk environment. They’ll only become aggressive again well into the next upswing.
It’s partly a problem of allocation methodology. The classic approach to risk/return tends to be backward looking. In current circumstances, the outcome of the classic approach is to be excessively cautious, with a misreading of risk/return leading to insufficient allocation to commercial property.
‘Individual investors and their advisers, too, are super-cautious after the bust’
This investment approach is not always risk-averse. It can be aggressive in the upswing, dominated by past strong returns and not able to spot the next cyclical downturn. But it is excessively cautious at the bottom of the cycle, with measures of risk and return dominated by the recent downturn. Hence the current excessive caution in equity markets.
We all know the problems of Modern Portfolio Theory. There’s nothing wrong with the maximisation logic. It’s just that we never worked out an “objective” way of measuring the expected return and the estimated variance of expected return, which drive the investment frontier. Usually, we just plug in historical mean and variance. We all know that that’s inadequate. But in most cases there’s no reasonable objective measure and most don’t want to take the responsibility for putting in subjective estimates.
In most cases it turns out to be a bias towards expectation of continuation of the latest trend. It’s hopeless at predicting turning points. It’s a recipe for leaving the stable door open when the horse is inside, and shutting the door after the horse has bolted. As investors, we need to understand value. And we need to be able to predict turning points.
I’m a forecaster. I know that most so-called “objective” theories are subjectively chosen. And I’m not afraid to make a subjective forecast. There is no choice, really, if we want to make good decisions. And from that standpoint, I know why the mean/variance estimates are wrong. But that doesn’t stop them from dominating asset allocation outcomes. And now they have property as a high risk/low return investment. They’re overstating risk and understating returns. And they don’t have enough allocation to property.
The real point is that expected returns for commercial property investment are high. At BIS Shrapnel we are forecasting internal rates of return (IRRs) of more than 15 per cent for most office markets over the next five years.
And risk is low. Indeed, that’s largely because of the GFC-induced correction in investment markets, in many cases leaving property prices below replacement cost. And it’s partly a result of the current excessive caution in both debt and equity markets, curtailing development and ensuring an increasing shortage of space over the next few years. Hence our forecast of high expected returns, initially as tight leasing markets drive rental growth and, later, as returning investors cause a firming of yields. And hence also low risk.
It was the period before the GFC that was risky. Weight of money, as investors geared up through the financial engineering boom, drove prices too high with associated risks of overvaluation, overgearing and oversupply. Fortunately for Australia, we were slow into development and there was little oversupply. But following the GFC-induced correction, none of the above sources of risk is high for new investment.
Certainly, there are lingering residual problems associated with over-geared entities holding property. Some are in the hands of individuals. But many are trusts, some listed and some unlisted, with little residual equity and unable to raise equity to reduce gearing.
There are plenty of examples of single-property unlisted trusts set up during the boom with 50 to 60 per cent gearing. Some properties fell in valuation by between 15 and 35 per cent, increasing their loan-to-valuation ratios beyond their covenants and leaving little equity for investors. Many of these constitute the banks’ problem loans. What they need to continue operations is new equity. But, unable to raise equity, and with little incentive for shareholders to allow change (they have little left to lose), these vehicles are in stalemate, waiting either for the banks to force them to sell or for a rise in the market to rescue them. They have no choice but to tough it out if they can.
Many investors have been spooked by this course of events. Some are locked in to their current investments. Many are reluctant to put new funds into the market, even through new investment vehicles.
But we need to recognise that these problems were due to the combined effect of high gearing and the fall in prices. The likelihood of further falls is remote. On the contrary, tightening leasing markets will ensure a recovery to replacement cost levels and beyond.
Investors, both individuals and super funds, will come back into commercial property. And there are plenty of opportunities in the listed and unlisted space, and through direct investment.
