May 20, 2023

“I can’t understand why people are frightened by new ideas. I’m frightened of the old ones.” – John Cage, American Composer.

Welcome to the Supplement folks, I hope it has been an enjoyable week. It hasn’t been, if you’ve spent your time sweating the Renters’ reform bill, or watching the bond yields. The US Debt Ceiling Crisis (yes, really, the C-word again – no wonder many people just ignore the news altogether) – a more accurate description would be the 37th sequel to the same old never-ending story – has affected the markets which don’t need too much to spook them at the moment. At close on Friday the 5-year is at 3.83% and the SONIA swap is back above 4% (just), which is where it was about a month ago. This puts a good yardstick of the cost of 5-year ltd co debt at about 6% (including amortised arrangement fees) – so anything less than this is likely a “take” – or at least a DIP – right now.


One of the realisations the US market has made this week is that it is Mid-May, and the Fed really might be telling the truth about not cutting rates this year. Sod’s law would dictate that just as they think this, something might change to change this fact; however, this is quite a revelation. New estimates are talking about cuts in 2024 – the reality of core inflation being above base rate still is possibly the biggest yardstick, even though CPI is now below their base. The UK might follow suit but the concern would be the timing here is about 9 months behind the US cycle right now – give or take a bit – and so the risk of there being not one but a considerable number of hikes in the pipeline is low, but certainly shouldn’t be written off.


On the reform bill, I’m not minded to write too much “in the now”. For those not familiar with the process, the bill has had its first reading. That’s the presentation – no debate. We have a second reading to come (no date yet) – with a debate over the general principles. Then committee, report stage and third reading (to agree the bill or not) – THEN to the lords. Then royal assent – then it is law.


With this in mind, I do feel this heads more towards the dystopian future of renting. The law of unintended consequences is important – for example, a record number of section 21s will be issued in anticipation of not needing to use this law – and not for typical reasons (85% of the time, rent arrears, supposedly) but because “cleaning house” for landlords before something like this is a typical result. This might be seen as the “cost of improving the sector” by Gove – we will see how far we get. There’s significant opposition in the Tory party but if Labour are going to put on a united front, I’m sure the bill will get through in some form or other.


However, I do think it is a good time to debate the general principles – the government website is “interesting”. The cliff notes:

    • We need a healthy PRS – I’m sure all would agree (although whether they will after the next election remains to be seen!)
    • Mention the tragic death of Awaab Ishak – think this is poor politicking because this is about PRS reform, NOT social reform. Just looks incongruent.
    • Dilapidated homes cost the NHS £340m per year – interested in the logic, but that is the soundbyte number.
    • The positive part: “Responsible landlords face challenges too – including when evicting tenants who wilfully do not pay rent or exhibit anti-social behaviour. “
  • Reforms aim to celebrate the overwhelming majority of landlords who do a good job and give them peace of mind that they can repossess their property when a tenant is behaving badly, or their circumstances change.
  • Section 21 to go – I’m quite controversial and unpopular in these situations. Landlords have abused s21 for YEARS and I’ve always spoken about the need to use Section 8 when rent arrears are the issue, and to issue the CCJ. By abusing the law (in the interests of following the least line of resistance) the law needs to change – that’s fairly typical of the law. No-fault, when the root cause is absolutely fault the vast, vast majority of the time – is not right and was never sustainable. This isn’t a “high horse” position – years ago, we’ve used s21 when we should have used s8. I realised it was a mistake and have ever since practised what I preach, but have been a lone voice on this to the best of my knowledge. There we go.
  • Easier repossession on grounds of arrears or sale. Sounds great – reality of the court system of course is that in its current iteration it won’t be able to cope.
  • Tribunal for fair rents if people’s rents are increased above-market to get tenants out – backdoor evictions stopped. This is a real problem, BUT the bill being later than advertised doesn’t help, because the reality is that market rents are up a lot, definitely a double-digit percentage.
  • A new ombudsman. Of course this will only work when both sides communicate, and in practice, the vast majority of evictions we’ve ever been involved with or aware of only happen because communication has broken down, because trust has broken down and promises have been broken.
  • Privately Rented Property Portal – well, this could be good if things don’t change every 6 minutes. If the portal does the work and uses appropriate technology, great. If it costs a lot and doesn’t really work – which is the typical reality – then, what a pain.
  • Pets – can be requested, as long as insurance provided. A good solution, but as usual – good tenants will have good pets, and look after properties – bad tenants won’t declare them, hide them and not buy the insurance.
  • The Decent Homes Standard will be applied – difficult to argue that this in principle is not correct, but the reality might be problematic in many parts of the country for a number of reasons – value/cost being one, which will lead to disposals.
  • Illegal to blanket ban benefits – well, I must confess I thought this was already done because of discrimination, but in reality this is a nothing, because rents are now so high that with a frozen LHA, these tenants are priced out in 80%+ of the UK, if not 90%+. Instead of the 30th percentile, rents are at the 3rd centile in some areas – so only 1 in 33 rentals would be affordable. Price is the greatest discriminator.
  • A strengthening of enforcement powers, and the reporting of them; more 30k fines then, hopefully not abused by local authorities – although those who work in this space will confirm that this is often not the case…..


Overall, one more straw on the camel’s back at a time where the sector is creaking, there is not enough supply and too much demand. Not ideal would be an understatement.


So, after not writing too much (well, the bill is the thick end of 90 pages), onto some reflections as to where we are right now.


The ongoing elephant in the room continues to be the actual value of yield-based properties. This has come up in bits and bobs, and discussed on our “Sunday Special” lives (9am on Facebook, LinkedIn and YouTube on a Sunday, if you missed it) – but I haven’t written anything comprehensive. To understand where I am coming from, we need to go “back to basics” and also take some lessons from economic history.


There is a model that was developed by some Nobel-prize winning economists. These are the sorts of people who don’t advocate getting actively involved in the investment markets – because the market is largely efficient. Now, many reading this will disagree – and many reading this are actively involved in the property investment market, improving their returns over and above the market return by putting in much more time and effort. They will also have a degree of control that you just don’t have in a public company, or REIT – the only control there is when to buy shares and when to sell them (which, in a liquid stock, is OK – until the time when you really want to sell and so does everyone else, and the market is closed, of course).


That model is called the Capital Asset Pricing Model – CAPM. We shouldn’t live our life by models – to be clear – but there is a concept that is useful within this model. It looks at the risk-free rate of return – so, what you can achieve without getting out of bed, as long as you have investment capital. The proxy for this mythical beast is the 3-month Treasury Bill – arguably never as much in doubt as it is right now based on the aforementioned Debt Ceiling “Crisis” but, the argument goes, guaranteed to be paid. That’s about 5.25% annualised at the moment – a BIG number.


Now, let’s talk about CAPM in reality. Since the rates hit the floor post-2008 crisis, that rate has traded in a tight range been 0 (2020-21) and about 2.5% (when the states tried to put rates up around 2018/19, then gave up). The reality is that thanks to quantitative easing, stocks have returned an absolutely fabulous premium on that risk-free rate – before the rates started to readjust in 2022 – of a little under 14% per year. So, the premium was more than 12% over that period – despite pandemics or whatever, which is an insane premium. Even the overperforming American market delivers around 10% return annually over 150 years or so; the obvious conclusion is that the market conditions were very favourable for companies, and whilst fiscal policy will have played a part, the reality is that monetary policy was the big driver of this overperformance.


Money has been made – a metric ton of it. There is SO much money around, looking for a home to continue delivering these sorts of returns – which, the long run tells us, are unrealistic. There are a handful of investors strong enough to deliver 20%+ returns over a long cycle – you’ll know the names, Buffett, Dalio, etc. – and even they don’t deliver every year of course. Private equity has blown up, gorging on the feast of cheap debt – frankly, if you can get the money and know the people, there have been some real penalty kicks when it comes to taking on unencumbered companies and loading them with debt.


Here’s the problem; this also applies to property. Data is much harder to come by for leveraged buy-to-lets, so I can share with you our own IRR in the sector – when considering total returns, it is well into the 20s and in some years has been in the 30s and 40s. Magnificent, although we wouldn’t have been able to deliver those sorts of numbers on the size of the portfolio that we now run. That’s very much a Buffett rule – give him a million dollars and he could double it in a year, but swinging a $600bn bat is a different matter.


Some of that was skill – great buying (if I do say so myself, how humble) – and decent delivery, and solid asset management. Some of it was done by the market – vastly outperforming forecasts that I made in 2016 when looking back at the period 2016-2022. Impossible to lose money, or so it seemed. But in reality, the same underlying principles benefited us significantly.

Don’t get me wrong – this was a very deliberate part of my acquisition strategy. Houses safe; interest rates low; rental yields very good (gross) and acceptable (net). Let’s fast forward to today.


Firstly – never had as good a set of relationships as now. That’s what you’d expect – stand up, shout a bit (occasionally), talk to people, give first and ask later – and you’ll find a really strong network of people who can help with deals, management, and the likes. This means that we can still trade fairly well in the “new environment”.


Gross yields are flying up at the moment, because rents are increasing so quickly. Net yields are going the other way, however, because even with stronger rents, the increase in mortgage costs, insurance costs, and maintenance costs, are frankly just larger. On existing stock with fixed rates – margins are improving – and we are lucky to have lots of those after last year, listening to my own advice and fixing an awful lot of debt for 5 years at 3.xx and 4.xx rates (and of course, I’m very annoyed it wasn’t at 2.xx rates). New stock doesn’t have that luxury, and has to fix at 5.xx rates, which means very small net yields, even when considering capital growth. I’m budgeting 2% per year over the next 5 years on average (we are always on the conservative side on forecasts, it is the only way I want to do it – this isn’t my prediction but my realistic worst case scenario, really), with some volatility – so that’s 8% annualized at a true 75% leverage (which very rarely occurs); not bad, as long as cashflow is positive, and that’s where we are staying. Still a long way away from the 20s, 30s and 40s, in a time where cash in the bank can make nearly 5% (although this is likely relatively temporary, it might well look like this for the next 12-24 months). 


So, you come back to buying well. Buying at market price is rarely wrong; if you are making cash doing something else, then shovelling it into property, with a modicum of skill, is unlikely to be “wrong”. It can be done badly; anything can; but still the risk profile remains low, as long as you put the requisite effort in in the first place to set things up correctly.


Still, there is a harking back to a “golden age” there, and this is very typical. One thing I learned very early on and tried to live by was the concept of wanting to buy more, earlier. I do feel in spite of this, and in spite of buying a lot, that more could have been done; so I suppose this feeling is inevitable to an extent. When you know the answer, you can change the question – hindsight is 20:20.


Does that mean it is all over? Not at all. How do we justify trading on at a thinner margin – well, standing still is going backwards in an inflationary time. We can still sell a property with 50-60k equity in it, which has drastically outperformed our forecasts, and put that money into a new leveraged project which is much larger, with a much more considerable rent roll, and are taking an institutional view to some extent; we believe rents will grow, and with that in mind our total returns over 5 years might not be impressive in year 1 or 2, but with rental growth they still look exciting and get well into the double digits.


My model has always been based on “money-in, money-out”. This was very hard or nearly impossible in 2021 and 2022, but is right back on the table in the here and now. March 2023 was by far our best trading month since 2019; 2020 started reasonably, but the start of the year is usually quiet, and then something happened in March 2020 to the UK market – can’t remember what…….


That of course improves IRR quite considerably. It still seems wise to utilise that model, to me – I wouldn’t want to be a capital allocator in this market, but then I also wouldn’t want to sit with that cash in the bank! I’ve said it a few times, harking back to the 1970s – as an asset owner in times of inflation, the game can become “who loses the least money”.


So, that is all designed to answer the question I get asked at the moment – “What are you up to, and how are you making things stack up”. If you aren’t getting 8% cash-on-cash yield (all costs in) when you buy something, you are risking negative cashflow which isn’t for me (and also risking not being able to leverage sufficiently, or negative gearing which I have explained before). 


If the majority of my portfolio was yielding under 6% at the moment, I’d be worried and I’d be selling off properties. This is what I referred to last week when it comes to the path of the rental market – Southern money now has to come North to expand, and the business case for selling in the South East is very strong indeed. The flip side of this is a likely bigger squeeze on rental market stock in the lower yielding areas, and it will get very hard indeed to rent. Great – you might think – this pushes rental prices up. However, if the tenants can’t afford it, this isn’t the reality – and if areas are already at their affordability ceiling, you are sitting waiting for wages to go up, which hasn’t been the greatest idea over the past 15 years. I’ve used inflation-adjusted average wages as the graph this week to demonstrate that concept. The purple line is the one to consider; look at the time that it most reflects at the moment, historically, and you can understand how the average family and the average business is feeling!


So – after that Renters Bill roundup, a theoretical, pensive and strategic overview this week. This landscape is changing and if you don’t consider changing your ways, trouble may follow. However, stay on top of things – read the supplement (of course) – Keep Calm and Carry On!