Supplement 130823 – A strategic framework

Aug 13, 2023

“Time IN the market, not Timing the Market” – Warren Buffett.

Welcome to the Supplement everyone. Whilst silly season continues, my reflection this week is less self-focused and more strategic. I know the occasional distraction is appreciated but I also know the vast majority are here to read about property investment and how the macro environment affects that – and that’s what you will get this week.


On the macro side, the US saw inflation tick up a little, providing some more fuel to the fire that there’s a sting in the tail. The UK Q2 economic figures were far better than I expected – and the month on month GDP of +0.5% is a massive surprise. The swaps ticked back up to 4.8%+ on the 5 year on the back of this. The volatility has been MUCH lower this week despite this being one of the bigger surprises for the past fortnight or so. As per the trend – “good” economic news is bad for rates although this mostly leaves analysts scratching their heads as the economy somehow carries on in spite of relatively unfavourable conditions.


The notable point though is that the overall underlying positive economic data was nowhere near as meaningful for the yield curve as it has been in recent times. This in itself is interesting and supports my theory that we’ve seen the high in the swap rate curve – it will be a long and slow ride back down but the direction is down not up. It would still be nice to see some better mortgage products and lower lending margins rather than the banks keeping all of that extra profit – but they can’t help themselves and will have to come under significant pressure first before they start to cut lending margins.


Halifax reported a month on month and year on year drop, but smaller than expected. The variable mortgage rate ticked up to an average of 7.58% (the average reversion rate from the big banks) – ouch.


Retail sales took a pounding coming in well below forecasts. The goods boom looks behind us at this stage…..the summer has been described in the US as the YOLO summer (you only live once) – will this sort of trend continue? This is a manifestation of the roaring 20s as mentioned during the “covid papers” although inflation and the economy will of course have a say as to how long this can last.


The RICS house price balance was down again to minus 53 showing how bearish surveyors are. As a reminder this means that more than three quarters of surveyors are seeing falling prices and a little less than one quarter are seeing rising or stable prices.


As we get into the meat, I always enjoy these quieter times in a summer. Normally it would be happy hunting time although we are still struggling to stack deals at this end, and so volume is still down. Nonetheless it is that time for taking a breath that leads to some of the best strategic clarity that I get, when the day to day melee moves to the back of the mind.


The way forward in the medium term looks clear. A runway of further rent rises, perhaps another 10% on new rents before faltering a little or simply returning to “normal” – but when I say normal, I mean moving with inflation, not moving behind inflation as they have done for most of the past 20 years (data before 2005 is sketchy I’m afraid).


Capital values stalling in nominal terms and thus continuing to deteriorate in real terms. A bit up, a bit down – a bit like GDP at the moment. Inflation coming back under the 5% marker which, really, is good inflation for investors when it sticks between 2 and 4 per cent, as long as wages stay there too.


In order to understand this properly, we need to consider a few scenarios – one of which we are currently living in, and one of which we have recently lived in – and understand the transitions. Let me try and lay those out. I’ve chosen two main parameters – House price inflation (versus wage inflation) and net rental yields (versus average cost of debt).


  1. House price inflation above wage inflation, and average net rental yields above average cost of new debt. This was 2020-2022 (most months of those 3 years). Great for capital values but inevitably meaning that capital value growth outstrips rent growth and thus net rental yields decay over a sustained period like that (as they did in the period in question). Houses get more unaffordable and whilst it is still possible to enter the market it starts to look less and less attractive as yields decay.
  2. House price inflation below wage inflation, average rental yields above average cost of new debt. This describes the period post-2016 referendum up until Covid pretty nicely. Houses getting more affordable but no-one shouting about it. Affordability for tenants actually looking good but likewise – this never makes good headlines so you never hear about it. Depending on the savvy and profit-maximisation motives of the landlords, rents could move along quite nicely in a time like this (new rents moved reasonably but existing rents actually stayed very static indeed as debt cost was slowly decaying over this whole period, improving profit margins).
  3. House price inflation above wage inflation, but net rental yields below the average cost of new debt. 2010-2012 would cover this as mortgage rates stayed relatively high (as swaps and bonds stayed comparatively high given the base rate) – and so the investment market was relatively static. London was a notable difference but this was International capital that was Mobile and looking for safe havens after taking a beating in the Dubai Market, or the USA, or the Caribbean, or a multitude of other destinations in 2008. In reality the cost of capital started to decay as this period transitioned into 2016 at a snails pace (Bristol, Oxford, Cambridge would be the exceptions – possibly Coventry also).
  4. House price inflation below wage inflation, and net rental yields below the average cost of new debt. Welcome to 2023! That’s where we are right now.


So what? Well, it has a short term impact on the sector which has long term consequences. In the days of housebuilding targets (currently suspended or abandoned), we started to hear about the need for new rental units, and some outlets published some quite scary takes on how many were needed. I remember one number being suggested around 200,000 per year. There are not much more than 200,000 voids out there to be filled this year in the UK – with no idea as to how many of those are under refurbishment, and zero chance of 200k new units. Net units are going down rather than up – and being stuck in quadrant 4 makes it very difficult to reverse that trend.


As the market forces work their magic, we WILL move from 4) to either 2) or 3) (and at some point back to 1)). So you can see what’s needed….either a move upwards in house price inflation (not right around the corner, I’d suggest), a move downwards in wage inflation (likely to be sticky as employees desperately try to catch up on the cost of living crisis), a decrease in the cost of new debt (likely, if my theory that we have hit the peak swap rates is correct, but currently I’d expect that to be a slow path back downwards below 3.5% in the next 12-18 months on the swaps), or an increase in net rental yields.


Bingo. That’s what’s happening and what needs to happen in the market to attract new buyers, and to incentivize existing asset owners to reinvest. Note my choice of metrics though. Net rent needs to rise. Gross rent is definitely rising, but higher costs (selective – which is rarely selective these days – licensing, higher compliance costs, EPC upgrade costs, increased eviction costs) can still choke net rent. 


This is where the fine balance of the PRS and local and central government need to work together – Ben Beadle is doing some fine work as the chief exec of the NRLA, but needs more support and resources. Here’s one basic and undisputed fact – investment hates uncertainty.


So – Gideon Osborne and his pals decided property should be for the institutions rather than the individual in 2015. 8 years later and the individuals have somewhat incorporated, and very few institutions have got out of the starting blocks. Yes, institutions are slow, but not that slow. There’s still too many questions to answer. These are what need ironing out before even thinking about being able to solicit sustainable investment (potentially internationally) in housing:


  1. I) What are the EPC requirements for the next 25 years? If not 50-60 years? That’s the term of a mortgage (if you are lucky) and these super tankers look at net present value and discount all future cashflows.


  1. II) What are the fuel input requirements for the same time periods? A similar point but not the same. Can existing gas boilers be guaranteed a 30 year time validity Horizon? Can new builds be told what they need and by when? Can the two be effectively and clearly split?


III) What does it take to provide a decent and safe home for the next 30 years? Free of damp and mould. Is it approached by age of wiring, windows, roofs etc? Is there another answer? What does the tenant need to be able to do to do their part in looking after the property? 


  1. IV) What will the tax regimen be for individuals, investment trusts, companies and other wrappers when it comes to property for the next 30 years?


You see the point. There are more. Nationwide licensing is inevitable – personally I’d say get on with it. But ENFORCE. This government has been pathetic at enforcement because their heart is not in enforcement anyway, from an ideological standpoint.


All those questions don’t need answering tomorrow. But they are the questions that the institutions are answering, I promise you. Lloyds are looking at how they grow as the largest bank in the UK – they have to get more involved in the best performing asset class of the past 40 years. John Lewis – it fits their brand image to get involved and their average store fits in an area that values at around £4500/metre, I’d wager – so an idiot can combine airspace rights and modular construction to make money there. It’s the rest that are needed.


Fear not though, intrepid readers. There’s zero chance of any of those 4 questions being answered anytime soon, because of the political cycle. Ideology will also get in the way – Labour will want to be cautious to appease its aggressive left and working too closely with the landlords won’t work. The Tories can’t decide whether they love or hate landlords but we do know they don’t care much for tenants. 


In the interim, we will stay in quadrant 4), hankering towards quadrant 2) most likely but at a slow pace. And so – what a fabulous time to buy this is. It is hard to get things to stack – but if a new purchase stacks today, you’ll be in for a Brucie bonus at refinance in 5 years time when the rate goes down 1.5% or more. The rent will have progressed if you’ve asset managed well and the margin will look great in 2028.


There’s another problem though. That requires patience and a long term mindset, and cuts out an awful lot of deals at the moment. The discounts you need are stark, or the yield requirements are sizeable. On low value stock at the moment I believe that anything below about 9.7% cash-on-cash yield will lose money, and that’s before bridging expenses or the cost of your cash, if you cost that in (I do). You end up needing above 10.5% cash-on-cash which is a far better metric than ROI, so if the TOTAL costs of a purchase were 100k you’d need gross rent of 10,500 per year to break even after all coats (in year 1). I’d expect a fair margin in year 2 with rent progression and things to look rosy come refinance as discussed. Still, 60%+ of my historic purchases wouldn’t meet this metric (and bear in mind I want a discount, not to be paying a premium for extremely high yield) – and I’ve been a yield chaser! So volumes remain low.


You can’t transact using leverage at the moment unless you are operating in high-yield areas or have flexible vendors. That means you either:


  1. Find your high yield area
  2. Find flexible vendors
  3. Find an equity partner to back you/co-invest.


I’m sorry to report that C is ALSO problematic because potential equity investors can get 4.5%-5% in the bank if they do a bit of tarting around, and similar yields on gilts if they are so inclined. Compared to less than 1% down those routes over the past 8 years or so. That throws another spanner in everyone’s works, but it is the temporary reality.


Back to our advantages. It’s great if you can get 5% interest today for 12 months or whatever. While inflation is still above 5. What about next year, when you need to reinvest at 4, let’s say. Or the year after when it is 3.5? By then I’ll have found my equity partner and be busy making double digit returns for both of us, not scratching around for a weaker return than the year before. That’s reinvestment risk and it would be wise to remind investors of it.


They may of course be like your average estate agent. Nowhere to be seen when they can get 5% in the bank but on the phone when they are struggling for 3.5% again. If that’s the case you were better off without them anyway – equity partners need to have patience and need to be in this asset class for the absolute security and the diversity of the returns it can provide.


The near term sees less rental stock and more demand until we get out of quadrant 4. Rents will be pushed to new, unheard of levels (although after inflation adjustments, they will look something like 2005 rents – and there’s a fair way to go yet before we get there) before the market rights itself. As wages rise and supply-shocked commodities readjust (although the oil price is creeping back up…..) affordability improves and there is a path for a more sustained period of rental growth than another 10%. Let’s not get too carried away though – it’s a fantastic time to buy, of that I’m sure, but those deals still have to stack……..


Enough strategy. Just one last reminder to Keep Calm and Carry On – but now isn’t the time to stay out of the market – if you can, get stuck in!