“Life can only be understood backwards; but it must be lived forwards.” – Søren Kierkegaard, Philosopher.
Welcome to the Supplement as we trudge through the sludge of January. The coal-face news this week has been almost all negative – both in my own group and in those businesses who are closest to me. No panic – just blockers to deals. Fixed rates promised last year (after the Trussterf*ck) – pulled. Deals falling apart or not happening. Vendors still refusing to smell the coffee that prices are down and likely on the way further down.
Part of the point of choosing the path of the entrepreneur is mastering your own destiny – however, this week things have felt like the market simply has too much to say at the moment about the stacking of deals. Mortgage rates are stubbornly high – as are the swap rates and bond yields – and, as discussed many times before, the risks remain to the upside rather than the downside.
Getting your head around the drivers of some of the macro forces at the moment is an endeavour in itself. The fact that we need an increased level of unemployment in order to stop putting rates up (to an extent) is a great example. The wording could be better here – inasmuch as that the key is getting inflation down, and the fastest way is to raise interest rates – and rates can theoretically keep going up until a recession truly is forced. You will hear people mentioning Paul Volcker – the US Federal reserve chairman who raised rates to 21% in the 1970s to control the wage-price spiral that had emerged in the USA. It is this piece of policy that mostly drives the conclusion that rates need to be raised above inflation to truly control it (that doesn’t mean above today’s rate, nor is it a mathematical identity or certainty, before you get concerned!)
The more concerning feature is that some metrics simply aren’t working like they used to – and some investment philosophies that have made money over several decades look somewhat risky at the moment. All in the backdrop of a stock exchange in the UK hitting record highs…….inflation clearly hasn’t dented the fortunes of the largest companies, nor has a weaker pound. Not yet, anyway (a weaker pound notoriously helps the FTSE 100 as so many of their revenues are denominated in dollars, apart from anything else) – although the pound has appreciated compared to a few months ago when being close to parity with the dollar.
The divorce between existing assets (which, if you handled last year and the opportunities with reasonable skill, look OK but are performing at reduced margins until rent catches up with inflation in the cost of provision) and new assets (which, as above, are hard to stack up at the moment) puts further considerable pressures on rents, as I see it. Think of the following factors and what they are doing to the market:
Continual pressure on landlords via the tax system and the law
Increased frictional costs in some parts of the UK (Scotland primarily)
Rent caps – both legislatively (Scotland again) and in concept (the mayor of London being a fan)
Vastly increased cost of refurbishment and maintenance – disproportionate to other inflation
Continued demand from owner occupiers
Recent capital growth and the incentive (despite a correction being underway) to cash in
Reduced cashflow thanks to other rising costs, and existing tenancies that cannot support an increase in rents.
Landlords organically moving on – passing away, changing direction, cashing up – without any organic replacement and with limited incentives for new entrants to the sector
More active asset management strategies (HMO, SA to name but two) that I have been talking about in order to sweat assets harder – HMO creates more households, short let creates fewer, but both create fewer family homes which is where the shortage of housing really shows itself.
There are no factors I can think of that are having an impact on increasing the provision of family-suitable rental stock at this time – only these factors that are going to continue reducing the amount of it for the foreseeable future. Simple economics tells us that with reduced supply and the same amount of demand (and demand is still rising – 504k net migration in 2022), price goes up when the market can afford it – which is one redeeming quality for existing rents, but does not change the mathematics of new purchases.
The investor market is far more sensitive to rates at 6% than the residential owner-occupier market is at 5.5% or less. The 5.5% affordability rules have been there since the mortgage market review over a decade ago – so the fact we are still under 5.5% and have been aside from a wobble over the course of a few weeks as the Truss/Kwarteng tag team did their level best to destroy the price of UK Gilts – means that on paper affordability is still the same as it was, although actual cashflow for new households using mortgages will of course be much lower than when pay rates on residential mortgages were 2% or even 1%.
Put this another way – the disincentives for first time buyers are nowhere near as pronounced as they are for investors at the moment. The 5-year fixes and the fluctuation in that rate completely determines the pay rate and affordability for rent coverage – at this point, buying existing tenanted stock with any attitude other than “get the rent up – fast” is difficult and leads to far lower offers than makes any sense, simply to avoid properties that are not cashflowing at all or are losing money after costs in the real world.
This is the January sludge. The implications of Truss at my end at the moment are: far better deals on paper quite widely available compared to the past 18 months – with less cashflow and that are less attractive than they have been for 10 years, because of the interest rates. Offers therefore become sharper – sharper than they have ever been. WIthout preserving margins, or at least trying to – there is limited point in buying. Buying to lower margins when already exposed to the market quite considerably – in terms of the cost of debt, the overall price of houses, and further changes in legislation – doesn’t represent good business.
There’s always a bright side, of course, and you’d be forgiven for thinking that I’m not seeing it at the moment! This isn’t the case though – the lack of activity has led to some room for continued planning and review of strategy for 2023, the luxury of time to look at some phenomena in real detail. I wrote extensively last week about alternative investment strategies – keeping the fire burning whilst the net present value of new property investments just doesn’t look as attractive as it has done for the past 12 or 13 years. The continued strategic review at my end led to a few reflections on my entire career, as it stands – 90% of which has been working on my own terms in my own operations.
This has led me down a very different youtube rabbit hole amongst other things! The central concept to what I’ve done over the years has always been risk management – and the principle that higher risks must lead to higher rewards, and – not just that – but disproportionately higher rewards. You could make the mistake of thinking this was just about money – but it really isn’t. To sacrifice your formative years in your 20s to a corporate entity, working 100+ hour weeks in some professions, is risky from a personal point of view – but to NOT do that is also risky because you are unlikely to be up for that – or to be considered to be up for that – in your 30s, let alone 40s and beyond – that is just one example of different ways of considering risk.
I’ve instead concentrated on my own approach to outperforming the average, when it comes to investments, or indeed when it comes to anything I’ve been involved in. A couple of concepts spring to mind – but what I’m effectively saying here is “don’t do the same as everyone else and expect a different result”. I work hard to push my mind into places that other people’s minds don’t – not accepting what I see in front of me, questioning, referring to source data, doing my own thinking and analysis. This is a rare trait, particularly in today’s world – but it isn’t natural, it is a very deliberate philosophy and way of life.
To outperform the average, from a mathematical basis, you don’t need a huge edge. There is a mathematical fact that many will not have appreciated, I’m sure – because very few people, even readers of the supplement, will ever have considered making bets with an edge. However, when we invest, that’s exactly what we do do – make bets, with an edge. In the ideal world, we take very little risk or stick to assets which have historically gone up the majority of the time – the property market, or, to a lesser extent in terms of how often it is up rather than down – the stock market.
Then, the next chapter is to compound that edge. Let me use the simple example of a football coupon. A typical football match might contain a 10% house edge, meaning that for every £100 you bet, the expected return against the edge would be £90. That won’t be the actual return, but the average return if you staked £100 10,000 times. If you fall foul to the football coupon, which is enjoying its 7th decade of popularity in UK betting shops, you will be invited to pick as many home wins, draws, and away wins as you think you can.
If you participate, and mix 2 teams together, both results will need to happen in order for you to achieve your payout. What you’ve done is increase the magnitude of the house edge – so your return now for £100 bet might be £81 – £100 * 90% * 90%. If you (like many) pick 5, 6, 10 or more results – you can see how the edge is becoming crippling to the house.
A quick lesson in why not to be on coupons there? Maybe. However, the important concept is that when you can act with an edge, you can combine multiple edges together in order to put the odds much more cripplingly in your favour. To stick with the coupon analogy, if I am a better predictor of football match outcomes than the bookmaker, I can combine my bets and instead of losing 10% each time I can gain 10% each time – then (whilst I am less likely to collect on my bets the more combinations I use) my edge can become fairly crippling fairly quickly.
This layering effect of multiple edges combined together is something that I’ve trained myself to use. The concept which I took from my experience in the betting world has most certainly been applied to the property investment arena. Ah – but how, you might well ask!
One example would be analysis of investment areas – this could be applicable to everyone on the scale they want it to be. Firstly – why invest here, or there? Demographics, infrastructure improvements, specific opportunities thanks to new businesses or perhaps the closing of old businesses or other facilities, a disposal from a large housing provider or investor in one area creating a temporary drop in the price in that area – I could think of many dozens of potential reasons.
Then – what to buy? Will the 1-bed flat or the 3-bed house provide the better long-term returns? The answer will be in accurately forecasted numbers, of course, taking into account all costs.
Then – HOW to buy? Open market, with agents you have not built a relationship with? Or auction, or direct to the vendor or by working with people who are direct to the vendor? You can see where your edge can be compounded here.
After that – how to fund? Equity splits – providing the legwork on the ground working with others who are time-poor? Debt, at sensible rates, from senior debt lenders and private individuals? At a more advanced level, debt provided by the vendor?
All of these at my end boil back to mathematical implications. If I am layering 3 or 4 advantages in a deal, and I have visibility of those and am better at pricing them, or making use of them, than the rest of the market, then that’s why I can pull off a deal that no-one else could.
This line of thinking is the one I’ve spent some time this week trying to advance. What other edges could be garnered? Looking at things in completely different ways, I have learned a number of hints and tips this week on this subject that I know a lot about, from years of practising it – gaining an edge against the house, or the bookmaker, when gambling. Now to leave those new found tips percolating in the back of my mind, and to work out how to apply those concepts to the property market!
I know from experience that taking a fresh approach – far easier when getting a fresh set of eyes into your business(es) – is the way to deal with challenging times. Sit back, reposition, reverse in order to go forwards. One step backwards, three steps forward. Analysis paralysis doesn’t help anyone – but while the maths is stacked against you quite so much, and the pace of larger deals and company acquisitions is slow, it is compelling for me to use the thinking time.
I hope that’s offered a different insight into the way that I’ve gone about thinking over the years, and building my portfolio. There will no doubt be more reflective posts over upcoming weeks and months, while I look at the current environment from yet more angles, and sharpen my battle plan for the way forwards. As always comments are very much encouraged and welcomed!