“The best way to predict the future is to create it” – Peter Drucker, the “father” of management thinking. The consultants’ consultant!
Welcome to the Supplement as we open 2023. I’ve not spent a lot of my downtime on social media etc – but the bits I have seen have been mostly people either lamenting over a bad year in 2022, or documenting just what a great year 2022 has been. This is fairly natural and a phenomenon I’ve talked about a lot over the past couple of years – binary thinking. It needs to be “good” or “bad”. It can’t be “within the 5 toughest years of trading I’ve had” (that would sum up my 2022, certainly in comparison to the 5 previous years – although I made some big decisions that were ultimately correct, which made the best of a rougher backdrop) or “one of my top 3 years”. Of course, we don’t tend to keep detailed records of all of this, and we also suffer from what’s called “recency bias” quite a bit – the recent past always has to be the best, or the worst.
It made me think of the above quote – we all need some luck in what we are doing, but also we need to create our own futures, not expect the market to carry us (as it did for all of those who owned significant assets coming into the pandemic). Of all the cheesy quotes, I really like “the harder I work, the luckier I get” because of the multiple interpretations that are possible here, but also the underlying message that luck and hard work are indeed related. An alternative is from one of my favourite Matt Damon films – “Rounders” – “You can’t lose what you don’t put in the middle – but you can’t win anything either”.
It also made me want to highlight that regardless of the macro backdrop, and my obsession with it, alongside my desire to make it understandable and relatable to property investors and developers who will put the time and effort into reading the supplement every week, there will be winners and losers. We need to default to the old “hope for the best, plan for the worst” when facing a year like 2023 with the runup we’ve had.
How did you do in 2022?
Here’s some advice I sent to a business contact early in 2022 – we’ve had many good conversations over the years, and he asked me what I would do in his position – basically, he was considering selling his residential portfolio, the income from which he relies upon to live. The balance was between capital values and the income on which he relies, with concerns over future legislative changes including rent controls (before Scotland had implemented their badly misguided policy from September 2022) – also alongside the rise in corporation tax which was already planned, and then scrapped, and then reinstated.
I replied citing secular inflation, with a likely 2-4 year window before it gets back to target, that stocks and bonds normally do badly in those backdrops. Both have taken a beating since this exchange of messages. Energy stocks and commodities would be the ones to consider (but this was post Russia going into Ukraine, so the prices were already high, so caution was advised). I recommended value stocks (those that yield well) and also a close look at commercial property, because there were some larger yielding assets for sale at yields that looked incorrect.
That’s still the case, in my view, as at today in commercial property. There’s been a refusal to accept that (for example) prime office might be in trouble or at least looks far less attractive than in 2019, and as always it seems we will have to wait for a slew of evidence before much more repricing goes on in that sector – it will be after the horse has bolted when yields really move. On the flip side, there are sectors such as some retail that are trading at yields that are simply too high in my view – when looking at the next 20 years of an investment. I’m not a commercial property professional first and foremost, it should be borne in mind, although I do have a significant interest in some commercial sites these days.
Sitting and waiting won’t make much for the next few years……
My own methods have built on this chat from around 9 months ago to move towards cashflow in the absence of buying solid stock at a decent discount. This has led me to looking at asset-backed businesses, and also trading companies that don’t own any property assets. There should be a metric ton of opportunity in this space over the coming year, as bounceback loans and other stimulus like CBILS, often linked to base rate, are sucking cashflow in repayments and often getting more expensive as rates continue to rise, which is the likely backdrop for the base rate for the first half of 2023 in the UK.
Stacking traditional momentum or what have come to be called “BRRR” deals at 6%+ 5 year fixed rates, simply to let, are very light on cashflow indeed. The mathematics just gets in the way, unless there are significant price drops in capital values alongside significant increases in rents (both are possible, but take time and won’t manifest within 6 months). I’m not in the 10% drop bearish team, personally, but I can see a tough market coming with a downturn in pricing likely to continue for the first few months; I wouldn’t be surprised to see a bounce in nominal prices at the latter end of the year to end roughly even or a few percent down. My “official” prediction for the record is that in 2023, UK house prices will fall between 3 and 5%, but I’d prefer a larger margin for error because there’s been so much volatility.
Will it all just calm down now?
Inflation and resulting strikes and social unrest are very likely to continue, and higher wages it should be remembered will put upwards pressure on rents and also capital values. The drag on the cost of credit, the debt from the lenders, will have the opposite effect of course as more and more people drop off their lower fixed rates to find much higher variable rates awaiting them; investors and retail punters alike; and this will at the very best affect the savings rates quite negatively in terms of what savings households tend to have behind them, but in reality will be disinflationary in the wider economy as well in terms of house prices.
I wouldn’t be sitting waiting for the “crash” since there is no guaranteed trap within the system that I see – plenty of reasons for those who predict a crash every year to do so, but with the accuracy of the Daily Express long term weather forecast. That doesn’t mean there won’t be one, but it does mean I haven’t seen the black swan just yet.
Rates, bonds, and the dangers
One cautionary note about rates, which I think are set for a decent period at around the 5.5-6.5% level for 5 year limited company buy to let following the last 10 days trading of December, is that the “near-bomb” that was defused was in UK gilts – the pension funds and the LLDI – Leveraged Liability Driven Investment – made a big difference to us. However, as described last week, the end of the “Widowmaker” and the falsely priced Japanese Government Bonds, also made a significant difference. Both of these could potentially pale into comparison with a similar event in the US system – a wobble to anything like the scale of the one in the UK system back in September 2022 would send shockwaves through the global bond markets, and this wouldn’t be a massive surprise to me. It isn’t an “odds-on” likelihood – and I don’t know enough about who is holding all of the US government bonds worldwide to take an informed position here – but if it can happen in the UK, you better believe it could happen in the US too. That sort of event would see 5-year rates back to 7% or so, the days of October 2022. We hope those days are behind us – and it is unlikely that they go much higher than they did back then, simply because of the damage that a 6% base rate would do to an economy that has become so dependent on cheap credit before 2022.
If you missed the memo where there was a wobble at the end of December – get your game face on, revise the gilt movements over the past couple of weeks, check the swap markets and make your decisions accordingly.
Deleveraging (using some money to pay down debts) will be quite attractive – why pay 6.5% when you can get that on your own money? I’d be cautious. Firstly, 6.5% isn’t the real cost compared to you using your own money, because debt is tax deductible (even for those hit by the dreaded section 24, there is still a 20% tax credit against the debt that you pay). If you pay 50% tax effectively on company drawings over and above 50k p.a. (and almost anyone will be doing exactly that, for the foreseeable future – 100k profit in a company taxed at 25% leaves 75k, any dividends over the 50k threshold are then taxed at 33.75% – another 25,312.50 meaning dividends come out at 51.31% effective tax), just consider how much using debt saves you in potential tax.
30 big, big bars down
Almost more importantly, also remember and understand what liquidity can do for you in the face of a recession. Dry powder is very, very powerful in these situations, as money is sucked out of the system. I posted this week that $30tn had been wiped off stock and bond markets in 2022 – yes, there’s been inflation, but the estimated cost of the 2008 financial crisis was in the $20tn region, so there’s 2 real conclusions from that. One is that we should put inflation into context, and those losses are pretty equivalent if we use the official inflation figures. The other should be that if we are expecting a bomb to go off, one has already done so – it is just because it has been relatively slow, difficult trading conditions with numerous bear market rallies – it doesn’t mean it won’t go down further from here, but a stock market that goes down from here but rallies to finish 2023 up would not be the world’s largest surprise to me. When you have significant economic events, the stock and property markets, alongside the macroeconomy, don’t tend to move in sync – often the stock market front-runs and the property market lags – one more reason why 2023 might limp along towards a challenging 2024, but I will reserve judgement as we see inflation unfold throughout this year.
Inflation this year? I thought it was all going to go away?
Ah yes, I of course have to move on to my most written about topic of 2022 (and 2021, for that matter). Inflation. My own numbers suggest UK inflation will average about 7.5% this year. It will be hard to keep wage increases much below that, and 5-7% looks like a good number even in the face of a recession which we are already in, without knowing the duration or the depth of it. The job market is the one major reason to be cheerful for everyone involved to be honest, although that in itself only encourages further inflation. This also will serve to hold nominal house prices up somewhat – hence my position on a relatively low drop on the back of some serious heat in 2020 and 2021 (and a market that probably ends 2022 about 5% up, once the ONS numbers come in).
Unemployment
On jobs, I don’t see 5% unemployment being breached or even tested in 2023. The market is simply too tight with still record-high numbers of vacancies, and in spite of 504,000 being the net migration number for 2022 (measured July to June) – it isn’t immediately clear to me how many of these economic agents are cleared for work, and the amount of focus the news media spends on asylum seekers and small boat crossings versus the major contributors here (Ukraine, and Hong Kong, for two well known reasons) – and remember this includes a lot of international students IN, without the corresponding number necessarily leaving as they didn’t come to the UK for 12-24 month master’s programmes in 2020 in large numbers because of the pandemic. Still, the hundreds of thousands who are cleared to work including those on skilled workers visas, coming in for healthcare jobs on a regular basis as has been the norm for some decades now, have not plugged the huge recruitment gaps that we are still hearing about.
Working from home? That’s all over, right?
This is pretty much all I want to say at the top macro level for predictions. What might be more interesting is regional variation – and the mix between urban, suburban, rural and coastal. Things have calmed down on the coastal front – largely – after a white hot market for much of the past couple of years. London particularly has also significantly underperformed over the past 6 years, after 6 years of very dramatic overperformance. Mean reversion, you might think; but I believe the pandemic had a particularly negative effect, overall. “They are going back to the office”, they say, but this seems to me to be relatively limited to a couple of sectors – if you go to the source data, which is always my preference, the ONS quite clearly shows even more people working from home in the most recent period published compared to just one year ago, when the “Omicron” variant was on the rise without consensus that this variant was likely the end of the pandemic, due to its far less potent strain (despite its ease of spread). 18% higher, to be precise – a really significant number. The source data is here for those interested: https://www.ons.gov.uk/peoplepopulationandcommunity/wellbeing/datasets/publicopinionsandsocialtrendsgreatbritainworkingarrangements
The city versus the ‘burbs
This leads me to suggest that the trend of urbanisation over many years is not yet ready to reverse back to type, without further repricing. A lot of housing is holding onto its legacy value, depending on what type of the country you are talking about. To translate this into regional predictions, I’m expecting London again to underperform other cities, but most importantly I’m expecting suburbs to outperform city centres, particularly those with easier or more attractive commutes and/or more reliable public transport (strikes, notwithstanding……)
Constricted supply of stock, ongoing
The sector is likely to see fewer starts, with fewer opportunities, until construction pricing has really come back to earth. A few more percent needs to come off some of the labour pricing that has soared over the past few years to see more sites come back to stacking up (and these are sites already in developers’ pipelines). Landowners need to swallow the pill they have never been good at taking in such times – land values, when GDVs are suppressed and construction costs are high, simply go down. There will be considerable edge for those that can deliver units at reasonable prices; but getting the really good deals to spend their time and effort on will still be a challenge, as vendors will want to see this play out before they believe the writing that I personally already believe is on the wall. It is ever thus – people are great at adapting, but poor at anticipating, and that’s just the way it goes with human beings in general!
There remains little more to say until we see the initial volleys in the stock and bond markets for 2023 – next week will look at a few more alternatives for navigating this trappy year! For now however……keep calm, and carry on!
