Around 10 years ago, the Great Financial Crisis was thrust upon the globe and there have been many reviews of what has subsequently happened, with a focus mainly on bond and equity markets. This quarter, we would like to present our own brief take on the crisis, with reference to UK real estate.
It also happens to be roughly 10 years since Keills was formed. We stepped into the market in the eye of the storm and have adapted our view on the market and our investment strategy accordingly.
We take as our start point the failure of Lehman Brothers, the US investment bank, which filed for bankruptcy protection on 15 September 2008.
Firstly, we set out some comparative metrics.
|UK Property Initial Yield||
|10 Year Gilt Yield||
|FTSE 100 Index||
|All Property Rental Index||
|UK Interest rates||
Sources: FT, MSCI, ONS
It is of course, the relative position of the changes which tells us of the drama that occurred 10 years ago. Interest rates bombed and with them gilt yields, following the humongous Quantitative Easing experiment, which is still being played out today. The recent increase in US interest rates and US Treasury yields is beginning to affect the price of risk assets like equities. Why would you buy risky equities at arguably a full price, when you can get a 3% return from Uncle Sam?
Despite relatively weak inflation over the last 10 years, prices have on average risen quite a lot and probably faster than incomes, perhaps pointing to a possible cause of the social unrest we are experiencing in terms of electorates choosing parties at the extremes of political choice. And that phenomenon is not restricted to little old Blighty.
The dramatic central bank assistance helped equities maintain their value by making such risk assets relatively attractive and the whole process permitted over-extended property companies and bust banks in particular, to re-finance with seriously cheap debt.
If the situation back in September 2008 was uncertain and governments were reacting to changing daily conditions, how does the position in 2008 compare with now? Today overall debt levels remain high and continue to grow at alarming rates.
However, we are told that the principal banks are safer. Certainly, they have offloaded much of the poor quality assets which pushed them close to failure ten years ago. What is less obvious is whether or not they have the required capital to fend off a similar crisis today?
Last time around, Central Banks stepped up to the plate but today their balance sheets are bloated. More relevant is the likelihood that most Governments would probably not get electoral support for the kind of bailouts that previously occurred. Given that other than a few executives being convicted for fraud in relation to LIBOR manipulation, none of the so called culprits have been prosecuted, much to the displeasure of the baying public, the appetite for further bailouts is low. Assuming that we can muddle through for many more years to come and actually pay off some of the debt, then there is a chance that economies can recover and put this crisis into the past.
Meanwhile, the 2018 column gives us some help in current asset allocation. Note that again property is a substantially higher yielding asset than both equities or bonds and quite possibly recognises the notorious illiquidity risk that investors in the asset class endure. Certainly, holding Government debt off yields of 1.6% does not inspire confidence when the yield trajectory is probably upwards. If bond yields rise, then the capital value of bonds is expected to fall and this capital fall is likely to make you lose money. This is especially true when the starting yield is so low that there isn’t an income cushion to help you over the short term.
We changed our strategy from being an active value add fund to investing in longer leases, where the rents click up in line with inflation. This change of strategy was implemented in 2010 and there is nothing which tempts us to change our view. The impact of the internet on retail has been well aired in previous quarterly reports, but it is fair to assume that there is more bad news to come. Only this quarter, we have had House of Fraser and most lately Coast the fashion retailer, falling over.
House of Fraser was ‘rescued’ by Sports Direct which it is feared may simply apply their “pile it high sell it cheap” model. Coast appears to be yet another victim to online trading.
We believe that other sectors will be adversely affected by the internet and so, keep an eye out for office rents weakening. This is not to say that you can’t make money from real estate, just that you have to be careful.
The expected lack of market level rental growth will continue to point us to investing in assets where rents increase via a contracted arrangement. It also strengthens our continued focus on owning assets where the property represents the ‘natural home’ of the tenant. The more we apply this rule, the more comfortable we are with it.