Sunday Supplement – 30/01/2022

by Jan 30, 2022

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Which property markets were up over 18% in 2021? This week’s supplement concentrates on volatility and noise – and how they are influencing the current world – and, most importantly, how concerned you should, or shouldn’t be, and some ideas of how to make sense of this noise and keep on top of it.

“The four most dangerous words in investing are: This Time It’s Different” – Sir John Templeton

The pandemic has turned up the dial on volatility, in many and varied ways. The tried and tested measure of volatility in the American stock market, the Vix (Volatility Index), started to go crazy in February 2020 – it has returned to somewhere near normal due to the previously discussed “end of the pandemic” – but that isn’t necessarily the case. A pandemic, just as a war does, casts a long shadow (although a different type of shadow to a war – wars notoriously push GDP up due to rebuilding of infrastructure as an example – but this does not mean a war is a desirable thing, all things considered!) Supply chain shocks are a great example of volatility that we’ve seen over the past 2 years, and the simple economic laws of supply and demand have been at work in a big way in the property market as well as the goods and consumables market. Demand dropping through the floor led to the now-famous negative West Texas Intermediate oil contract in May 2020 trading at negative numbers (i.e. you got paid if you could take oil). Smaller, but strange, things have happened to many markets since, particularly in commodities.

This week contains quite a bit of volatility – politically at home in the political system/10 Downing Street, foreign policy wise in the Ukraine with the Ukraine/Russia border situation causing a potentially significant international incident. There’s also been the more “traditional” risk-off volatility in the stock and bond markets. This is an interesting time – for at least a year, markets have moved to fresh highs and more fresh highs that have been beyond the expectations of many experienced traders. That same experience knows that when you have a crack-up boom, which is never based on fundamentals anyway, that it can continue for longer than could possibly think it would. The inflationary environment of last year was no surprise – but the markets, particularly the bond market, ignored it until very recently. Suddenly there’s a massive shift in the markets that is now pricing in FIVE rate hikes in the US this year. That also seems unlikely to me, because if markets take a real dive after the first hike or two – OR there is a large hike upwards, “large” being more than 0.25% at one time, and the market hates that at the best of times, which this isn’t – the Fed is highly, highly likely to behave differently. There are also various narratives available to it to justify not tackling this via rates (not immediately, anyway). The Bank of England is dealing with some similar situations, although they are, happily, not quite as extreme – fiscal policy over the past couple of years has in my opinion been “won” by the UK versus the US, which is quite unusual in recent times; this has given UK monetary policy an easier time as a result.

There’s also a lot of positives at a time like this in reminding yourself, and any fellow investors that will listen, that this is a long-term game. In the past 30 years, property has vastly outperformed any other major asset class, particularly when the returns are risk-adjusted. That’s reflected very well in the sort of price that you have to pay for debt; clearly, banks feel that the right way to price a residential mortgage on your own home is very close to a price where they have very little margin at all (or might even lose – but they get you as a client and get all the associated banking services, where they can make a profit by cross-selling to you). The underlying quality of the asset, plus your own motivation to ensure your own roof stays over your head, equals effectively a cost-price loan for many people in the current market. Buy-to-let has been different – but of course, the “skin in the game” argument at the bottom of Maslow’s hierarchy of needs does not apply for a buy-to-let property.

Questions worth considering at this sort of time are: What would you do in an event of a 40% drop in the stock market in a relatively short period of time? What would you do in the event of credit withdrawal in the mortgage market similar to 2008? Visualisation and planning around disastrous scenarios can be powerful (just don’t do it on a daily basis!).

The recent volatility (and remember, markets can go down as well as up, but fast rises are also an example of volatility, and we certainly saw enough of those last year with some specific UK “hotspots” climbing 30%, or more, in price in ONE year!) has manifested itself in a conversation we have been having in our auction buying business, this week. There are 4 parties to that conversation:

Me – final signoff of decisions, have put the structure and systems in place to create an effective business and income stream which also builds wealth
A – highly analytical and very logic-based, hard to move from a position, never shies away from taking a position
B – wants to do deals, finds a reason to get things done, can spot ways around problems – default position is to buy rather than not to buy
C – follows the process, does the “first pass” on stock, creative and allows “curve balls” to influence/will give them airtime, great vision and experience in what can be done on the practical side of property development

My take on recent volatility is that we need to be operating to the end values that have been evidenced by the market in the past 18 months. The RICS position essentially (because we are second-guessing a RICS survey on a theoretical end product that doesn’t exist yet, but we do know the location of it). That’s easier said than done, however, because the comparables within 0.25 miles, let’s say, might have transacted in March 2021, or June 2021 let’s say.

Let’s put another layer into that. That property is around 95-97% likely to have transacted on the open market at a fair value with a lot of competition, especially in a year like last year. The average transaction was taking around 100 days, so let’s use 3 months as a proxy and say those deals were struck 3 months before the completion date that hits the land registry. So the 2 examples above were agreed in December 2020 (in a lockdown, going into a bigger lockdown) and March 2021 when we were still languishing in lockdown 3.0 (or thereabouts). Since those transactions, the market has moved on quite a lot – how much? The land reg can tell us that with perhaps a small allowance for the months that are yet to process, with a nod to the Halifax and Nationwide price indices.

THAT is the market price. Bear in mind we are effectively projecting about 6 months into the future because that’s when we will come off the auction financing and onto the term financing. That’s what works for us – others will of course use different financial structures. So we need to get that right.

So that covers me. A wants more to see in hard text what the market had done at those points, because they are the only real evidence that they have. I disagree. B wants to project forward and say “well, you know what, we can put another 5% on these because the market is still hot”. I disagree, again. C is concerned that we’ve had a crack-up boom last year and wants to be quite defensive on an end value, thinking that the market is odds-on to pull back.

Whilst that’s only four of us, that’s a nice little market. We all have the same information. We all have our own biases. We all have a decent level of experience. But, what’s the right answer? Is there one? It’s an effective and functional team that has an A, B and C in it and someone to (sometimes) arbitrate but to come in and inspire to get the right deals done. It’s also a meritocracy and we recognise when one has done something exceptional, and we also recognise (in a “black box” kind of way) when someone has made a mistake, so that we don’t repeat it – and our mantra is that we’ve all made a mistake because we didn’t pick up on it, so there is no individual blame when things don’t go as we might have liked.

A does fewer deals at a bigger discount and the quality is higher. B does more deals and in absolute terms likely makes more money, but is bearing more risk to do so and putting in more effort to do so. C puts deals on the table that others would not have seen and does not allow themselves to be constrained by the rules that are set out, and adds an extra tilt to what A and B do. Is this helpful if you don’t have a team and an A, B and C? Yes, I would hope so, because aside from anything else you can consider which one you are, which one you definitely aren’t, and ideally you can learn to move from A to B to C accordingly when the time is right/when you are appraising a deal. And there’s D, E, F and G to consider who are not necessarily physical presences within your team, but useful hats to wear/personas to adopt when considering a deal.

If we zoom out and consider volatility at a more macro level, after that segue – we would be most interested in the context of the interest rate. It is important to remember that the drop to zero/near-zero in the interest rate in 2008-9 was not the first time in history that’s been done – it is standard monetary policy in the event of a depression or very large recession. It was pitched, alongside the further expansion into quantitative easing – again, not the first time QE has been deployed, QE was not invented in 2009 – as a temporary measure that’s effectively still going on (yes, the UK has had events including the Brexit referendum, before the pandemic, that “got in the way” – but the US hasn’t necessarily, and there will always be the next crisis, particularly if the media have their way!). A temporary measure in its 13th year……

To further this point, there are the inevitable differences between the UK and the USA to consider – from a public perspective, the USA is the one country in the world where the stock market is the most important to the voting public. Their exposure, their retirement plans, their overall near-obsession with stocks en-masse is unrivalled – and so the stock market becomes so much more of a political tool. The central bank is of course apolitical and independent…….just as the moon is made of cheese! Well, maybe not quite that far away from the truth, but you can imagine that there are timings in election cycles which are considered when some of the monetary policy is being set. The S&P 500 has seen a near-10% drop from its high on Jan 3rd, although there was a minor recovery last thing on Friday; but there’s lots of intelligent chatter about “what happened last time this and that happened” in the stock market, and all sorts of Jeremy Grantham-esque positions being taken by people as well, expecting the “crash” – 10% off the top in a month is fairly painful, whilst not in true crash territory.

In the UK, the path of the market has been very different over the past couple of years anyway – so this stock market mania has not been replicated. The US property market has also been far more bubbly and accelerated well beyond the UK – and that is without some of the structural constraints of the UK (although it does of course struggle with delivery below rebuild value, the average house is still cheaper to build per square metre in the states). Last year, home prices of a typical 2,000 square foot “single-family home” as they prefer to call them in the US, increased at 18.6% year-on-year.

Interest rates in the UK have a likely “new normal” rate around 2.5-3% in the medium term. That’s been the thoughts from the Bank of England, when they have vocalised them, in the past 6-7 years – and there have been a number of knocks and shocks that have pushed that medium term further away. This doesn’t mean the maximum, of course, but more of a steady state rate. What we can’t do is assume we will live in a world without an interest rate of any meaning forever – although Japan shows us that it can be a very long-term proposition in terms of our own lifetimes.

The overall direction of travel doesn’t sound good – although we need to remember just how much cheap credit we’ve had access to, and STILL have access to – I must emphasize that – and in fact I’d like to put some more colour around that. This is likely to remain as good news for us as property investors – the current shape of the UK yield curves is looking a bit “amber” on the Red-Amber-Green risk rating system, with shorter term yields climbing faster than medium term ones, but the 5, 7 and 10 year bonds which hold the most interest and sway for us as property investors are not climbing overly rapidly. They have definitely moved upwards – the US more towards 1.8% for 10 years, the UK more to 1.25% for 10 years. This is obviously still outrageously cheap, and in real terms those returns are getting absolutely hammered by the inflation rate of 5.4% UK, 7% US at this time. The US yield curves are performing normally, the UK ones are a little flat between shorter and medium term debt, a move towards a potentially recessionary indicator.

This, plus margin for profit and also considering operational expenses, is where the money for the longer term fixed mortgages come from. I think you can make the best case for a decade for fixing rates for 5 years (or more) at the moment – as always, it will depend on the premium that you pay for that. However, the shape of the curve today – which will influence products that are released on the mortgage market in the next few weeks, a highly competitive market at this time with thousands of product offerings, means that you are likely to see a rise in 2-year and 3-year rates that is larger than the rise in 5+ year rates. The 3.xx debt is not in any meaningful danger as of yet – but the direction of travel is upwards, so I will emphasize what I said a few weeks ago – don’t hold back, get things done, get those rates locked in and manage that risk, arbitrage it away with the generously low rates on offer at the moment. It’s worth a reminder that if borrowing at 3.1% (say) and inflation is at 5.4% – at this time, in real terms, they are paying YOU to borrow the money. What an opportunity!

The direction of the money supply is also relevant of course. The tightening in the US – who as discussed before, are keener to unwind the position in their own Government bonds that they have built up than the UK are, despite having far fewer of them in relative terms – does affect the “money needs a home” or TINA – there is no alternative – arguments. Money doesn’t need to keep piling into Tesla, or crypto for that matter – and is also already harder to come by than it was during the times of the pandemic stimulus. This is predicated on the tightening actually happening – because the Fed have “cried wolf” many times on this before.

This will in the course of the year potentially play out in the wider markets, on the subject of availability of money. Consider bridging and development lenders, for example – there is always major pressure to deploy funds. There is more competition than ever before. The market has been absolutely awash with money. They get to see an absolute ton of deals (if their marketing funnels are effective, of course) – and have to turn down the majority of them as a rule. Asset quality is an issue. Those who have found ways to lend on almost anything and bend the rules, for the right clients, have always had a significant advantage and that will continue. However, with money that has non-utilisation clauses, when non-deployment is so expensive (as it is when inflation is ravaging the cash that is in the coffers) – there is a danger of pushing money into projects that are not as good, not as viable, and don’t have the affordability – or, in plain English, bending the rules for the wrong clients, rather than the right ones.

That, historically, has always had bad consequences, and there’s no real difference in why this time will be any different, if some of the lenders do fall into that trap. The larger institutions have a flight towards even bigger, and more – the build to rent sector is growing at a rapid rate, and the cost of funds are so very low in a world where funds can be raised at a couple of percent, or lower, in such projects – I still remain unconvinced that they capture the real heart of the UK tenancy demand, particularly in any secondary locations/anywhere but the big cities or the most affluent towns and suburbs, but that’s for another time! I do foresee some white elephants in that sector, though, in the coming years.

In conclusion, I think we should be steeling ourselves for more “crash” headlines, and my advice would be to look past all the noise, and the media hype, and take an interest in the 5 and 10 year bond yields, so that you can see the realistic cost of funding and how it is moving; ignore the noise, keep calm and carry on!