Supplement 110623 – Domino rally?

Jun 11, 2023

“The most confused you will ever get is when you try to convince your heart and spirit of something your mind knows is a lie.” – Shannon L. Alder, author

Welcome to the Supplement folks. It’s been a confusing week of mixed signals, as this week’s quote attests to. As usual I’m going to try and pick through the macro before getting into some detail about the quagmire we are currently battling through.


On balance, in mixed news weeks I have a tendency to believe the true balance is likely more positive. Let’s face it, the media have a tendency to over-report the bad news; despite the sky falling and the word crisis being used 100 times in the past few years, things still lumber on and somehow they even lumber on somewhat sideways and upwards.


We saw more lenders pulling products, as the bond yields remained relatively robust. I know this will sound ridiculous to some, but as investors generally speaking we’ve been somewhat lucky in the overall sudden shift back to high or normal interest rates carnage of the past 18 months.


Let me elaborate. The yield curve – the plot on which the bond yields of various durations are displayed – has for some time been particularly high at the front end – traditionally a solid indicator of a recession – and then somewhat subdued down to the 5-7 year mark – and then moved up again from 8-10 years and onwards, to 30 years and beyond. 


To translate that into plain English. The expectation has been a short term period of higher rates, perhaps 6 months to a year – before cuts back down to maybe 2-3%, but then a need and desire to return to slightly higher rates in the longer term. 


It’s the shape that’s changed this week, and overall that’s not helpful, because in many ways that shape was the ideal one for us as investors. But why? Well, because we tend to use 5 year fixed rate mortgages. It’s the way the market has developed over the years and the way we’ve been cultured. In reality the institutions that tend to rely relatively heavily on bonds prefer the 10-year bond – it’s the bond with the most liquidity – and although we stay in our houses for an average of 22.3 years in the UK, the 5-year mortgage product has been popularised.


There are a number of reasons for this. To an extent, the product teams respond to demand of course. It’s consumer behaviour. If everyone would genuinely prefer 10-year fixes – well, they’ve been offered down the years by quite a few providers, and consumers would have spoken, and everyone would have needed to offer them. How many things can you observe in life that happen just because “they’ve always been done that way”?


The industry isn’t much incentivized, either, to try and push this duration outwards. Brokers would prefer you to refinance every 2 years – of course they would. That’s the way they make money – nothing sinister about it. A shift from 5 year fixes to 7 year fixes, all else equal, would mean it took 40% longer to meet every remortgage date, and needed more new business to stay where they already are. It’s simply business.


Lenders are not quite incentivized in the same way. They simply need to hit their IRR (internal rate of return) targets over the period, and might prefer a longer duration, although there might be another perverse incentive in there around ERCs. If 20% of 5 year customers redeem early and pay an ERC, thus improving the IRR, but 40% of 7 year customers do, then those loans would be more profitable, not less. Do longer durations lead to more credit risk though? On interest-only loans, yes, arguably they do. There’s just more time for things to change and potentially go wrong. However, there’s also been more time to make capital growth even more of a certainty, so that tempers that problem somewhat.


So what’s really happened? Well, as alluded to last week, the market has really finally woken up – for the moment – to the reality of secular inflation. It will take a sustained period of elevated rates to beat inflation in its current form. We’ve got inflation news for May in the week after next on the Wednesday, and the Bank of England meeting on the Thursday. May’s core figure is likely in my view to be down, and perhaps down a little above consensus, simply because April’s move upwards was a touch false – that is bound to make a big difference. This move in market expectations is what’s changed the shape of that yield curve.


The 5-year swaps – remember, the basis on which the majority of buy-to-let mortgages are prices – are half a percent higher than they were a month ago. Half a percent is, of course, a lot in what’s already a tight market. Half a percent on interest rates at the moment will make a significant amount of buy-to-let properties unviable, or negatively cashflowing. It can quite literally change an investment decision at the margin.


The 7s are about a quarter percent cheaper, the 10s more like 0.4% cheaper. That gap is widening, and has nearly doubled in the past month. If 10 year money gets to 0.5% cheaper then you are looking at potentially unviable properties on 5 year fixes being only viable on 10 year fixes.


That’s all good in theory, at the computer keyboard. In reality, products take time to design, fund and launch by the lenders. If they know 5 year demand has been gigantic, and 10 year demand has been anaemic (historically) then only if they take an “if you build it they will come” approach (bearing in mind their data on “when 10 year is 0.5% cheaper than 5 year” will be slim), will those products get built.


If it was me, I’d suggest you could make them look even cheaper by justifying a higher arrangement fee for a 10-year, and get the pay rate down so that it was 0.75% cheaper than a 5-year, based on these swap rates. That, I believe, really would make a difference in consumer behaviour. Also – if the market feels this might well not be sorted within 5 years, or at least on average we will have elevated rates for more of that time than not, which is a better representation of it, I’m sure – then going “to ground” for 10 years would be better. ERCs could be more punishing in the first 5 years of those terms (as an example).

Also, the Bank of England, who were always particularly nervous around BTL landlords in terms of them dumping stock quickly (or getting repossessed) in volatile times when Mark Carney was governor, would surely prefer longer terms? There’s definitely an argument that more should be being done at the top level to encourage longer product terms at the moment, in my view.


We also dealt with Halifax numbers this week – “the first time prices have dropped on an annual basis since 2012”. May ‘22 is certainly near the peak, and the market does feel a LOT more than 1% cooler at the coal face than it was 12 months ago. That’s more a function of fewer people overpaying (in my view) than it is of impending doom. The product withdrawal of late May/early June this year will not have helped improve confidence, and will put a hole in August’s figures for ‘23 I’m sure. As usual the world continues to have the wrong conversation around all of this – how about a positive spin that on the basis that prices are down 1% in nominal terms, and wages are up 6.7% in most recent figures, makes houses nearly 8% more affordable for the average person?


The flip side of that news, however, was the continued move in the right direction around the RICS house price balance – still well in the negative (-30) but moving in the right direction. For a -30, you would effectively have 35% of surveyors reporting price increases in their area(s), and 65% of surveyors reporting price drops (35-65 = -30, 35 + 65 = 100). The forecast was -38, and the graph for the past 25 years is today’s graph, because it puts all this into context. Still negative, but moving in the right direction – RICS surveyors are also not, overall, inclined to be considering overall inflation in their assessments (in my view) and so this is trending back towards the positive. The first negative figure was recorded in October 2022 (yep, cheers Liz) and that was for the first time since early 2020 for obvious reasons – however, the balance was negative for most of 2018 and 19, but prices still limped forwards rather than backwards in those years, so it is not as clear cut as “negative means prices dropping” – it is more a leading indicator of the market to an extent.


Construction growth moved upwards, and again was above forecasts; also, retail sales grew year on year but perhaps most significantly in the UK economy, the service sector continued what is bordering on a boom. 4 months of growth, a number above 55 (50 is not growing or contracting, but these numbers tend to be much closer to the middle than say the house price balance), and reports of robust price increases and demand for services. This gives strength and confidence in jobs and also in wages, of course. We have employment figures next week and they are the other key ingredient in the mixer for the Bank of England MPC.


On the subject of the MPC, the market is expecting 0.25% to go on rates on June 22nd. For the first time in a while, I am in disagreement, and probably blindly faithful that the bank will do the right thing and go 0.5% this month. The unemployment and inflation figures will change these numbers before now, but the most recent market take looks like 80% chance of 4.75% and 20% chance of 5.0% at the next meeting. 5.0% would mean lower rates in the shorter and medium term; but there we go (and of course, I could be wrong!).


My view is that 0.25% does nothing to calm the swap and bond markets, whereas 0.5% calms them significantly. The 0.25% will simply be added on 6-7 weeks later anyway; the difference is marginal, but Bailey could really stamp some authority on the inflation situation by sending a 0.5% signal here. Let’s see. Rates not rising at all at this meeting is really unthinkable at this point.


The broader news in the property industry, beyond the macro that bores so many but fascinates me, remains fairly bearish. Lots more “10% drop” headlines this week – again, failing to factor in secular inflation, in my view. I’m not bullish today but a 10% correction from here in prices would surprise me. 


The eurozone technical recession is the non-news event of the century, frankly, as they just happen to be on the slightly wrong side of 0 – we are literally in an environment where the UK is not in recession because of 0.1% of growth or breaking even, and the Eurozone is because it shrank by 0.1% and then 0.1%. It could not be a smaller technical recession – I had to mention it, but safe to say we should conclude nothing other than what I’ve been saying for many months – hovering around zero, recession or not, is limp, unexciting and needs to change.


The only other thing I’d like to comment on is the Handelsbanken professional landlords survey for 2023. Firstly, let me profile these customers. They are not particularly price sensitive – other lenders are, frankly, cheaper and often faster. They will not have high LTVs – I have never heard of over 65% with HB, and they’d rather tell you that 50% on commercial and 60% on resi is absolutely the highest they will go. They will also have a larger number of customers than the average resi lender who are on floating rates; so you’d expect their customers to be feeling pain at the moment.


In other news though, here are the comments from the survey replicated, from the Handelsbanken website:


“Despite the economic uncertainty, large portfolio professional landlords are in a confident mood, with the majority planning to acquire at least one new asset in the coming year, new independent research conducted on behalf of property business expert Handelsbanken shows.


Other key findings include:

  • Six out of 10 are set to acquire more properties in the year ahead 
  • Of these, over half plan to diversify into new sectors 
  • 92% expect to see valuations rebound 
  • London and South East cited as most attractive regions 


The Handelsbanken Professional Landlords Survey – based on nationwide research among large UK investors with an average of 29 properties worth c £14 million each – found that 59% plan to expand their portfolios in the year ahead, underlining their confidence in the long-term value of UK property as an asset class. Just 14% expect to sell some or all their properties.


Over half (57%) of those looking to buy more properties also plan to diversify into new sectors, with offices (43%) attracting the most interest as investors look to take advantage of depressed valuations.  


The overwhelming majority of respondents (92%) expect the value of their portfolio to increase over the next 12 months, with 39% predicting it will grow by over 20%. Only 8% thought it will broadly stay the same.

James Sproule, UK Chief Economist, at Handelsbanken said: “The bottoming out of commercial property prices in Q1 2023 corresponds with reasonably positive sentiment expressed towards the sector in this survey.


“Commercial property values saw a major correction in the second half of 2022 as a direct impact of the higher interest rate environment. Average retail property prices were down by 15%, office prices were also down by 15%, and industrial unit prices were down by 25%. 


“In addition, there are the ongoing considerations around post pandemic working practices and retailing habits which, until they are more settled, will be weighing on commercial property valuations.”


Geographically, three-fifths of respondents expanding their portfolio are also planning to buy in new regions. London was cited as the most attractive region over the next 12 months by investors (27%), followed by the South East (26%). Areas seen as less attractive for property investment are Yorkshire and the Humber and the West Midlands, both attracting interest from only 9% of the sample.


This interests me and these opinions must be respected. Let me start with where I’m absolutely on the same page. I feel we’ve seen or are close to the very top of my range for swap market pricing. Remember, that’s not the same as the base rate. If we did go 0.5% on base this month, I think we would have seen the top – but if we don’t do that, as the market is suggesting, then we’ve got a danger of bubbling over this recent top again. With that in mind, you’d expect commercial property to have moved more quickly (and the Q1 ‘23 figures are a surprise, but not a massive one – and the data around offers and particularly industrial are fascinating), and if the rates have found their top, then it has found its bottom – put simply – because it is so interest-rate-sensitive.


This also speaks to the mindset of the big players. Buy low, sell high – they are buying not selling because they have cash (remember the low LTVs of this group as well), and really only ever think long term. This seems very sensible.


39% expecting a >20% growth in portfolio value? It isn’t clear how much is due to expansion versus capital growth, but that would be a fast rebound meaning a quicker drop in interest rates, which is not congruent with where I am on the subject, but again I have to respect the opinions of these bigger players of course.


Office being a good sector to enter at these low prices – makes good sense, although I think it is more complex than this. I’ve been saying this for some time – the mix needs to be different, but the sector is of course attractive at prices far lower than in the recent past. The RTO (return to office) trend is real, but not significant in truth – working from home numbers have become particularly stable, and workers are clearly resistant enough and currently have enough power to be resistant against this trend. I think bigger offices need breaking down into smaller, serviced, HMO-style units without a doubt – these are much more robust. The problem with the larger buildings is that those taking them on are only downsizers really, although of course some businesses will buck the trend; there are more sophisticated offerings also that can add value, such as premium offices for companies where their brand needs to be particularly strong; this applies in different quantities throughout the country of course.


Also interesting that so many are planning on new regions – makes some sense, and on the bright side could be a “levelling-up” sort of play; it could also be that their own regions they feel are saturated, but taking your expertise and using it somewhere that you don’t know is a bit of a leap of faith of course.


So – that concludes a longer-than-usual macro roundup, but that survey I thought was worth sharing. Onto the micro bullets for the week:


  • I’m finding vendors more receptive to deferred consideration, vendor finance, and creative structures in general than they’ve ever been since I’ve been doing this seriously (12 years and counting, although some would say I’m never overly serious!)
  • Certainty is at its peak at the moment
  • Remember price drops are unlikely, although valuations have started to and will continue to suffer a bit – much more likely is that properties simply won’t transact
  • This is a long game not a short one
  • Buying cash to refinance down the line is better than leaving cash in the bank
  • Even if prices go down 5% over the next year (the most bearish end of my range), if rental yield after costs is 7% you’ve still made 2% – not a bad worst case scenario
  • It’s likely not the week to lock in too many mortgage products, consider waiting another couple of weeks
  • It’s absolutely the time to be prospecting for properties where vendors are on variable rate mortgages since we have an effectively guaranteed rise in 10 days time
  • If you haven’t for a while, make sure you are stress testing your portfolio
  • Don’t panic. Never panic – but if you have problems to deal with at the moment, debt related or otherwise, make a list of them, discuss them with those that you trust, and reach out to people who can help – Partners in Property is a supportive community
  • Make sure your asset management is up to speed. Last decade’s rents quite literally help no-one. When that tenant eventually needs to move on, they won’t be able to afford to – and what then?
  • Get your head up and above the parapet (and out of the screens/newspapers or similar) – the weather is amazing and that lifts everyone! Less time on negative news, more time on you.
  • Fix the roof while the sun is shining. Assess the next 5 years of your business(es) or portfolio. What happens when those nice rates you fixed last year (because you read the Supplement, of course) come to the end of their terms? What’s the plan then?


And finally……of course…….keep calm and carry on, folks!