The UK economy is facing a period of high uncertainty. The
odds of falling in a recession (in the short / medium term) are significantly
higher than average in my opinion.
For an investor / saver that would like to do something with
savings, real estate investments on low/zero leverage are probably a good asset
class at this point. A decent alternative to cash / fixed income.
For a developer that would have to borrow money in order to
finish a project, the risk is that the economy would plunge into recession
before the units have been sold, increasing bankruptcy risk in proportion with
the debt load assumed.
A developer would do well to reduce the risk as much as
possible: selling the underlying properties at the earliest stage possible,
pushing therefore the risk on to the buyers and their creditors. Developing
properties that have already been sold leaves the developer exposed only to the
fortunes of construction development.
Once the clouds over the UK economy dissipate and the
economic outlook is brighter, if yields in the real estate sector continue to
be around the current levels (which is possible because prices depend to a big
extent on salaries and income, which move slowly), then owning property (with
leverage) and letting it will probably result in very good risk-adjusted
returns.
The British
economy at a crossroads
Defying the consensus of economists, the British
economy didn't fall into recession following the Brexit vote. The British Pound
seemed to do some of the adjustment to avoid it, but as it became clear during
the first stint of austerity pursued by G. Osborne, the depreciation of the
pound didn't help to improve the balance of trade (especially vs European
partners).
The drop in the Pound Sterling might have been the
catalyst to avoid the recession actually: the British consumers correctly
anticipated a rise in inflation following the dramatic plunge in GBP and
front-loaded purchases. The data from the balance of trade, and from private
sector debt creation --credit cards
especially-- underpins this hypothesis.
In the GE of 2017 the Tories lost most of their
majority. The electorate, as it had already done with Brexit, seemed to reject
a continuation of the status quo. In my opinion, a reaction from the Government
is needed just to maintain the status quo. These are the traffic lights for
investment in Real Estate --at this juncture, as perceived by the writer.
***Red light: the UK economy is on a steady
trajectory towards a recession within the next 6 / 12 months. The probability I
assign to this scenario is 55 / 60 pct.
***Amber light: the Government realizes
that the private sector is overwhelmed by credit and heading towards a
recession. Westminster chooses to stimulate the economy via an increase in
spending. Private sector balance sheets could be slowly restored over time.
Interest rates could be raised somewhat without pushing the economy towards a
recession. Probability around 40 / 45 pct. The economy would continue to grow
between 1 and 2 pct pa.
***Green
light: the Government realizes that the private sector has no vision for an
improved national economy; which on its own, is also unable to turn around the
current account balance. After appropriately comprehending the situation, the
Gov decides to implement a series of programs aimed at improving the prospects.
Mariana Mazzucato
might have been the most vocal among the economists about the kind of
investments that would have high ROI (R&D in sciences. Increases labour
rights: less full employability and more full employment'. In my opinion the
current Government is very unlikely to change tack in such a manner. This
agenda could be pursued by a more
progressive / socialist government led by J. Corbyn (chance 70 pct if he becomes PM. 15 / 20 pct chance his
government focuses on price controls rather than stimulating demand)
Asset
pricing on Real Estate
Real Estate is a real and tangible asset. However,
depending on the area, the values of the
properties stem primarily from the value of the land
rather than from the bricks and mortar.
**In a scenario where supply outstrips demand, be it
because Brexit triggers a loss of jobs, or because people move from city Dear
to city Cheap, housing prices can drop --without a bottom. Prices could be
found at discounts relative to the perceived value by both buyers and sellers.
It would be a buyers' market with low volume. Housing prices aren't volatile
though: they are sticky; and sellers are reluctant to accept prices they don't
like if they aren't forced to sell. The shared loss of confidence (and the
deterioration of household balance sheets) would rapidly trigger a recession
and this would require the Government to come to the rescue --with the
automatic stabilizers and the chosen discretionary fiscal stance. Needless to
say, house supply would be significantly reduced until confidence is restored.
**In a tight market where supply and demand are in
equilibrium or demand outstrips supply, housing prices will move rapidly to the
price range that reflects the costs of bringing new supply to the market. (Land
+ materials + labour + profit margin for developers). This is what sets long-
term prices in a healthy market.
--
In relation to the components of the returns exhibited
by real estate:
Materials and labour are the sources of the
'inflationary hedge' return. Those are very real assets and jobs that will go
up in price in line with the costs at the time of development.
The value of the land is linked to the health of the
economy; primarily to the path for Total Factor Productivity (meaning that if
TFP raises quickly, one would expect land values to follow suit; and
vice-versa).
Take-away message: The implication is that following
the Brexit vote, demand might be subdued, and we aren't seeing a tight market
driven by the costs of new supply. Total Factor Productivity doesn’t have great
prospects, but the inflation hedge (provided by labour and materials) would
kick in: developing property today costs more (in construction materials) than it did before GBP depreciated.
Macro
Musings
After having been below zero for several months, real
interest rates are hovering around zero. This means that an investor can hope
to get a return equivalent to the expected inflation avg. for the 10 years of
maturity for a standard Treasury bond. Approximately four or five percent more
if willing to take the risks associated with investing in the stock market.
It is not true that Central Banks implemented
extraordinary stimulus measures following the GFC, that once reverted, will
allow us to go back to 'normal' interest rate levels. What is true is that we
suffered a big recession caused by the incompetence of policy makers (both at
central banks and Treasuries/Govs); and that Central Banks had no option but to
reflect the new equilibrium in the financial markets and the economy. Australia
took appropriate measures and did not fall into recession. It still hasn't. The
ECB raised rates in 2008 and twice in 2011. It lost its compass and the
Euro-zone economy suffered the consequences. G. Osborne also flirted with
austerity and the results were recreated.
So there is no 'policy normalization' to be expected.
There is no normal level for a T-Bond; and just because the yields during the
90s were around the average yields had during the 80s & 2000s, it doesn't
make the 90s normal. If one looks at the path of interest rates over the last
200 years they are all over the place. There is no signal in the noise.
Capitalism tends to over-production and over-capacity. We have arrived (again).
Interest rates will be very low for a long period of time (or until significant
capacity production is destroyed). Borrowing makes sense (if spread is low).
The level for interest rates is set by the big
economies; primarily the USA, JP and Euro-area in second term; and they put
pressure to any economy that deviates (unless capital controls are erected
(Iceland, China, Brazil). The bond market and the stock market already reflect
the new reality internationally. It can be argued that Real Estate is the
exception: it is the highest yielding asset. It continues to offer the
risk/return tradeoff that it offered prior to the Global Financial Crisis. In
my opinion, buy to let and build to rent are strategies with strong
foundations. Taking debt exposes the investor to default risk; but it will
likely be a yield enhancer as well.
My perception is that the UK has a high probability of
recession, but that housing is a good asset class to own. European real estate
investments offer similar yields (with differences); their economy has a much
lower probability of recession, but the monetary experiment is dysfunctional. Countries
like NL, DE, SE, DK have the best risk/return tradeoffs in my opinion. The UK
would join that list as soon as it realized that, like the latter two, it is a
currency issuer that isn't subject to financial constraints.
