Sunday Supplement – 09/01/2022

Jan 9, 2022


Welcome everyone to another Sunday, and I’m inspired by the start of a new year to start with a zoom-out to where the world currently sits on a macro scale. Context is incredibly important – but just like in any business or indeed your whole life, if you just get up, sort out what’s in front of you that day (whether it be business, pleasure or both) and go to bed at the end of that day, you have very little capacity or opportunity for change, or for effectively forecasting the future. In the investment game, forecasting is mandatory – if you aren’t consciously doing it, I bet you are subconsciously doing it (example – why buy property? Your inherent belief is that it will go up over time, and then after that we get into the finer tactical points like HMO, SA, single let, etc. etc.). But a snapshot/short sharp shock/reminder is a good thing, and what better time to do that than the start of a year.

This week will hopefully make you think, and as always I will welcome challenges, prods, pokes and all comers in comments! Firstly I want to take you back nearly a decade. I was sat in an interview for a strategy consulting role at one of the “big 4” accountancy/audit firms, and the interview was with the executive partner on the team. It was a niche role within a massive organisation, because they had sold their strategy consulting book off some years back, and, as usual, decided to rebuild it once the moratorium had expired.

I was asked how to go about solving the strategic problems that someone like Proctor and Gamble have – and first of all asked to suggest what they would be. I started from a vision way out, because the problem for a massive multinational is generally two-fold – firstly maintaining market share and maximising margin and therefore profit in its developed markets, and secondly developing new markets in developing countries, often with explosive population growth. The current forecasts suggest population growth will top out at around 2100 at nearly 11 billion – so my first answer was that that will pose a serious strategic problem for a company like that. Markets will actually be shrinking. If you go a bit further, IF the capitalist system is still the dominant one on the planet, this will mean really serious extra pressure on it. So – as discussed – too far in the future! (I then went on into a more “near-term” summary of what I saw as their issues, but that’s beyond the scope of this for today).

So – 2100 potentially sees the end of growth (to an extent – it is still possible to innovate with a static or declining population of course). Of course, before then we could be colonizing Mars or somewhere else if the visionaries/luminaries/mega-cap owners have their way. And its only a forecast. But what does that mean for us and our more realistic/recency biased time horizons?

I like to be thinking at least a decade in the future. In many ways this is why I chose property. I face the reality each time I get very strategic that acquisition might not always be the dominant strategy. Holding may be, and also disposal may be. The case for disposal (when you are thinking inter-generationally, and I do think like that, but as a possible outcome rather than a guarantee) has to be quite strong, because disposal costs are significant. Frictional costs of buying and selling are significant – you need to either work to relatively thin margins (as many of the volume auction traders and cash buyers do) in large volumes, or do what 99.7% of the investment buyers do, and buy to hold. Some make the mistake sometimes of coming into property as a short-term investment – or not doing their research and asking themselves the tough questions, the primary one being “will you be up to the battle?” because that’s how it feels sometimes.

Acquisition in a meaningful way is great. It really suits me – I love the thrill of the deal, the numbers behind making sure it is a sensible move, the potential – the new street, town or city, the new people involved – all of this really suits my personality. Yes – there’s definitely effort – so there needs to be a really compelling reason, for you, to keep calm and carry on. For me, it keeps the machine moving, it moves myself and my partners closer to our goals – it ticks the boxes. Some days I ask “what else would I do?” and in the pandemic, I guess personally I’ve learned some of that, at times where acquisition was pretty much impossible thanks to markets being closed, effectively; or where prices ran away so quickly that direct to vendor leads were unworkable and auctions simply had insufficient stock.

But back to our nearer-term view. What will happen this year? That I attempted to cover last week. What will happen this decade? That’s so much harder. It is really folly to even attempt to predict it, in a meaningful way – which is exactly why estimates of the top for global population are “about 11 million” in “about 2100”. Suitably wooly, given how far away we are from those numbers or years. We have markets that offer investment opportunities up to 50 years or even longer, on a fixed income basis – government bonds is one example. Some 55 year gilts were issued in 2013, although realistically 30-year is normally as far as they go into the future.

This longer-term market is of interest for the price of debt on 5-year fixed rate mortgages, which have become a very powerful weapon of the investor in the past decade or so, but given even more power after the change in the PRA guidance in December 2017 around debt servicing ratios, especially for those with properties that have a low gross yield, based in London and the South East. As rates have fallen – and make no mistake, we need to ignore the base rate here to some extent – as 5 and 10 year bonds have fallen in yield, these 5-year fixes have become cheaper and cheaper.

Often, we only talk about what goes wrong. What annoys us. What gets in the way of growing our portfolios, or businesses, or even ourselves. Normally, the dominant strategy is to “own” as much of this as possible. We can’t control the interest rate, the 5-year bond prices, etc. etc. However, we can act in a whole number of different ways potentially:

i) consolidate and pay down debt with any excess revenues
ii) fix for 5 or even longer terms on debt to minimize any disruption
iii) sell off properties in order to pay down debt on other properties
iv) take out variable or floating rate debt if we feel that the price of the “insurance” of fixing is too high

A mixture of these is also valid, of course, and likely is sensible if you have a considerable portfolio (and that’s before considering other investments/assets that you might own).

We also have hardly given any mention to the fact that mortgages have slipped down from around 3.75% – 4% nary a year ago (I’m limiting this to 5-year fix, limited company, 75% LTV) to as low as 2.85% – 3.1% right now. The beauty of trying to get this right is that time is on your side – these rates are relatively slow to move. A lender has to get a tranche of money, advertise a rate, incentivize brokers, and get valuations and get loans done. That slab of money is then more or less profitable than predictions based on operational costs, variance, and a number of other factors.

That’s an incredible decrease in the cost of debt. However, in this zoom out, I want to make it clear that that extremely purple patch – the “nut low” as they call it in poker circles – has been reached. In the UK anyway, for (in my view) the next decade. The last time I was as bearish on the direction of interest rates was 2014, and that time round, I was definitely wrong (but had there been no Brexit, perhaps I would have been correct).

There’s a long term trend down to “ultra-low” that’s been going on ever since the 1980s, as a hangover of the economic mistakes of the 70s to an extent, and also as credit has absolutely swamped the economy. But it isn’t as “new” as some commentators make out – government debt has been around for hundreds of years. We as a country have owed a much larger proportion of our GDP in debt – yes, it took a gigantic generational event to force that position, a world war – but a pandemic should not be taken lightly as far as historical events go.

That very long term trend looks, to me, to be endemic of the post-Bretton Woods era after the Nixon shock in the 70s. In plain English, it is set to continue whilst the rules of the game stay as they are. How likely is the status quo to continue in the next decade? I’d say 90-95%. If you’d asked me in 2014 (for example) I’d have said 99.9% so that is the movement in my thinking in that time, and the enormity of events such as the stimulus provided by the government during the pandemic.

However, the 3% days are over in my view. There are some arguments that give some peace to the debate, and this isn’t a “PANIC” moment where rates are going to spiral out of control by any stretch, so please don’t read it as such. Margins for lending to limited companies are fresh air, of course, and so making debt much more expensive for limited company BTL versus personal BTL has never really stacked up. That’s a bit of a simplistic argument, as well, to be honest. What you could say from a savagely commercial perspective (as a lender) is that following 2015 and the “clause 24” Osborne budget, the number of limited companies being set up to buy and hold property exploded in number. There was no real data on just how creditworthy this route would be, or whether there would be further legislation that “levelled the playing field” as some speculated there would be (or will be in the future). That meant a larger premium/margin was required to allow for this risk.

What time has given us now is 6.5 years worth of data, which lenders will be privy to. More repossessions for limited companies versus personally held BTLs? I doubt it. I’d suspect the converse to be true, although sadly I don’t have access to this data. Of course, property has been held within limited companies for many decades, but the volume explosion means that the last 6.5 years worth will be the data of interest. So, because money is a commodity and there is very little loyalty between consumers when it comes to taking out buy to let mortgages, then the amount of money out there to lend/that larger banks and financiers want to deploy, plus the growing market in limited company loans versus the shrinking market in personal BTL loans, means that the margin is being squeezed. A classic “perfect competition” economics scenario is emerging. This is a good direction of travel for us as borrowers.

However, the move upwards, relatively quickly, in interest rates will negate this in the first quarter of this year, and push us back up into the 3.25 – 3.5% territory fairly quickly, in my view. So what? If you are getting a serious amount of debt, because you want to fix, because you want to re-gear, because you are on a floating rate that isn’t competitive – do it NOW! Pull your finger out and crack on. It might only be at the margin, but I really feel we are at the bottom here.

What does that mean in the medium term, and over the next decade? Likely to go back to 1% base rate in a reasonable timeframe. There will be at least one wobble. I’m predicting that at 0.75%. The Bank of England is likely to move the rate again at the February MPC meeting, to 0.5%, in their enthusiasm. The rate expectations keep going up and up, at the moment, whereas 12-18 months ago they were going down and down.

This is marginal stuff, in absolute terms, unless you are borrowing millions. However, I always keep the words of the British Cycling team legend, Dave Brailsford, in my head (whilst Sir Dave has had his share of criticism in the past year or so). Marginal gains. 1% here and there. Makes a massive difference.

When we look out to the next decade, we know as direct property investors we have challenges to face. The EPC situation – how much money will be needed? Where will it come from? Will there finally be a meaningful and workable grant scheme to get the PRS where the government want it to be? If not, how will that impact the business case for buy-to-let and investment property in general? And that’s just one (admittedly, major) strategic issue for the next decade. Every bit that we can do will make a difference, every decision we can get right. How about the inflation in maintenance costs, although rents are going up at least as quickly, of course.

Perhaps you will conclude that bad debt stays bad, and good debt stays good. Perhaps you will conclude that debt is a good thing in a period of sustained inflation, if indeed that is where we are at. (and what number represents sustained inflation? Anything above 2%, while the government secretly rub their hands in glee at a 3.5% average rate if that’s where we end up over the next 2-3 years?) You’d probably be right, certainly on the second count – and that’s where my head is at. The target for the next decade will be 2.5% on the base rate count, perhaps leading to a 4.5% rate or so on the average mortgage – I don’t see this is a certainty by any means, but you certainly want to be provisioning to clear decent returns on a monthly basis, at well above this rate if you want to be able to gear up and have a cashflowing investment business!

Left-field this week, I know, but hopefully it has made you think, and imparted what I see as one important shift in the direction of travel – I have alluded to it before, but the strength of the data is such that I felt compelled to devote the entire article to it this week, and as often happens I have shelved a few things in order to get this done.

Next week I may finally get to slide in something I’ve wanted to talk about for a while – the death of Occam’s razor – that will hopefully get the juices flowing for a week from today!