Supplement 260223 – Evolution

Feb 25, 2023

“The wisdom of crowds is sometimes overwhelmed by the madness of mobs.” – Andrew W. Lo, Adaptive Markets: Financial Evolution at the Speed of Thought


Welcome to the Supplement! Another interesting week at this end, for a few out-of-the-ordinary reasons which I wanted to share. Last week’s half-macro, half-reflective piece went well, and it seems appropriate to do another on a different topic, again with multiple meanings. Evolution.


The quote for this week is, as always, deliberately chosen. I have found the wisdom of crowds to be incredibly useful in everything I’ve ever done for “work” since I left school. One theme that will run through today’s piece can be introduced here – and there’s another half-dozen or so quotes or cliches I could use to make the point – but I’ll stick with “the trend is your friend but not at the end.” Back in 2015 I was questioned, and sometimes derided, for my views on where certain property markets were going, in terms of relative performance to others. I’d like to think I’d still be telling the story if I hadn’t been right – and of course, I wasn’t 100% right, because, as often, I perhaps overextended myself with the precision and breadth (you can usually have one or the other, not both) of my predictions.


My main contention was that London’s meteoric rise in the early part of the 10s could not continue. It was absolute bubble territory. Sealed bids, 20%+ rises annually in certain boroughs – it isn’t hard to call these things, but it is hard to call the top. However, the data was clear – the froth was off in Prime Central and that was spreading to Inner London, it was already happening. Even Grosvenor Group were selling PCL assets in Mayfair – that seemed to me to be a surefire tell that they thought they were overselling them, by some considerable margin. That all turned out to be correct.


The quote came into play here. The wisdom of crowds in the UK very much suggested that property ownership was the way forwards, and renting property was also a very sensible investment strategy. I saw it as one with effort, a lot of moving parts, a changing landscape – but if approached well, very, very little risk indeed. I’ve preferred to make really solid returns – sometimes eye-watering IRRs on individual deals – right at the bottom end of the risk scale. Lots of front-loaded effort, and then maintenance and asset management. I’ve preferred 25%+ returns in a year, compounded again and again, to 100%+ returns which require inordinate amounts of risk that I didn’t feel I could control particularly well. 


However, the madness of mobs also suggested that these were bandwagons that should be climbed upon. The tide was very strong; only a few voices were with me against the overall chatter at the time. I remember three other particular ones distinctly – all of us have invested outside of the M25 since that date, in different partnerships, together – and all of us have returned some solid figures by doing that. In the current environment, where 6% gross yield is nowhere near investment grade, London without some fairly salty asset management strategies, or else at low loan to values which usually means some very ordinary returns on equity which could be equalled or bettered elsewhere, for less effort and similar risk, we’ve backed into a fortunate position where our assets still stack up even in the current mortgage market environment. However, for new purchases, things don’t look so good.


This view, like everything, has had to evolve over the years. It remains under review; I believe the long term trend towards urbanisation, the uniqueness of the UK and London as a critical centre, and as a city so very much larger than Birmingham, Manchester or Glasgow, will see London well in the long run. However, there are also affordability issues that have existed since the early 2010s in terms of rental ceilings, and much larger incentives for people to live out and commute, meaning less need for incredibly high and rising rents in zone 1 or 2. It has stood up well over the Brexit result and implementation, and also during Covid, for reasons that I did not forecast, see or understand in 2015. They simply happened not to have helped. But – the trend was your friend, but not at the end.


I’m always on the lookout for bandwagons of concern. The entire market has evolved in a strange way over the past few years, although it does make sense with a reasonable pinch of the facts here. The Covid stimulus inflated property prices to the extreme, supported by the cheapest debt that we had ever seen as bond yields sank to effectively zero in early 2021. It was nearly impossible to get returns without some form of risk – and 6% yielding property, before costs, made a lot of sense back then. With a loan at 3% or even lower, the charge was on. The crowd were being relatively wise – although perhaps a little too short term in their thinking, unless they fixed mortgages for at least 5 years (ideally more, in hindsight, although I was only doing a few 7-year loans that came up, and that was just for diversity rather than anything else). 


Prices were bid up so far, and so fast, however, that yields were crushed fairly quickly. Then, inflation stopped just being something that some of us were talking about, and became reality. Rates had to go up, of course, and yields were up before bank rates were, meaning the days of the 3% mortgage were numbered. In property terms, this was all relatively fast-moving stuff, and also relatively volatile. We then (I say we, I mean under 100,000 Conservative party members) elected a lunatic into number 10 who put an abstract theoretical economist into number 11. The theory was wrong, and the country panicked. This was definitely the event that knocked the froth off the top of the market – and perhaps at a great bit of timing, because a Truss legacy may well be that unintentionally it stopped the market turning into a bubble overall. We will see if it really is just a down market, OR it was a correction that washes out say 6 months after the budget – April will, as it often is, be a big month fiscally after next month’s statement (Wednesday 15th March, by the way). I’m not convinced we are in a downward spiral at all – I expect the figures, after the Truss effect has washed out, to flatten out a little and perhaps even pick up again as wages continue to rise (as industrial disputes rage on). 


This is really fast evolution. The supplement has evolved – in 2020 we were talking about pandemics, property, and the way life was changing in front of our eyes (and occasionally lockdowns, Sweden, and dare I say vaccines). Over the past 18 months you wouldn’t believe how much time has been spent looking at, and talking about, and making sense of, bond yields. This past week really seems like the week that the markets around the world have evolved into the new normal. Here’s first of all what’s happened and second of all, my take on it:


The yield curve has remained inverted, but now goes very clearly – up, down, up, down. The spikes are at 6 months (so a high probability of a recession remains) and then between 20 and 30 years (which are showing over 4% on Friday’s close). Happily or luckily for property investors, the 5-year segment of the curve and a couple of years either side remains at a manageable level, but at 3.65% or so it is still 0.8% higher than early Feb after the last Bank of England meeting when it touched 2.85%. In plain English, that means you can expect the total cost of financing a property on a 5-7 year mortgage to wash out at about 6% per year (the headline rate may be lower, but I’m including arrangement fees, etc.). Quite a blow to new property purchases in low yield areas, if leverage is required or needed. 


The reasoning? Well, the financial markets have finally woken up to what’s seemed to me to be the writing on the wall. The economy is not in anywhere near as bad a shape as predicted, but is still teetering on a knifeedge. This level of inflation is not good for companies and earnings, because they cannot pass on all of their cost increases to their customers – they end up internalizing some (and taking a hit on their margin). Nominally, profits look better – but in real terms, they cannot keep pace, generally. This is a classic inflationary market (although you wouldn’t know it, to look at the stock markets). 


The rates will be higher for longer. As I’ve been saying for some months – the focus should never be on the peak rate, although that’s the question everyone wants answering – the focus should be on the duration. Base looks to have evolved momentarily to trade in a range of between 3.5 and 4.5% for the next few years. Now, there’s plenty to come yet, but to see much lower requires a fairly significant negative economic event, such as a sharp or unexpected recession, or an energy price crisis, or a credit crunch. A few years is a long time – as today’s efforts document. 


So – we also as investors need to evolve. The past 3 years have seen 4 significant pivots in my group strategy as an investor, who invests primarily in property, primarily directly, always in the UK. We switched from a very successful BMV model buying from traders, to buyers of unwanted development sites and tenanted properties that were underlet (mostly the latter), to buying limited companies with property assets in, to buying companies or businesses from administration or distressed situations. You can’t be an expert in all of these things, of course, although they are inter-related. That evolution is still continuing, and weeks like this (I’ve been on the move, or the hop, or on half-term duty for all of it!) give a little bit of extra time to think, because you are not at the coal face day to day. 


To put that into context, I had made 1 or perhaps 2 pivots in a decade before that. That’s evolution, and management of change. It helps and it hurts. It means one thing the world hasn’t yet woken up to as well – a repricing of risk. 


This is important. REALLY important. Go back a dozen paragraphs or so – the crowd were wise when buying 6% gross yield when bond yields were zero. Market rising, let’s assume 3% a year on average over the next 20 years. 6% gross, perhaps 4.5% net, then leverage and capital growth? Yum yum. Existing assets financed at those rates for 5+ years? Fantastic.


A lovely premium on a set of risks which I would maintain can be controlled, although effort is needed. Let’s get to today. 4.2% for 30 years in a Government bond. Perhaps a return to 6% yield on average, with 6% being the average cost of funds as the market is placed today. No leveraging up at all – simply stretching your money further by using leverage. That same 4.5% net of operating costs is a 0.3% premium over the bond yield curve, or is only 6% of the premium from 2 years ago. 


As the yield curve stands today – perhaps not great rates in 5 years time as well, or perhaps not much difference from today. Hard work managing assets to get rents up each year, which is (again) the new normal. The evolution. Some of us have been doing it for many years of course, simply because we’ve taken a very commercial view to the whole game – but those rises that were relatively nominal but still worthwhile across the group, have got to a stage where the expectations should be around 7% this year even if you have managed rents well over time.


Now, should we sling out the baby with the bathwater? No, not at all. This is the week that the world really woke up. The long term trend is still deflationary, progress in technology, less physical goods to live on, more online/in the cloud. Growth will struggle, particularly in the UK. That leads to a necessity for low interest rates – a similarity with Japan over the past 30 years, although with better growth prospects than zero – although 1% looks realistic (infinitely more than zero, of course, but not a great progression in the overall standard of living). 


This evolution, then, is a range for products to trade between. How do you take this on as an investor? Well, pick your spots. Balance your risk. When you see a good value product – don’t hang out for another one, as I’ve been saying – take it! That gives you 30 days in principle and if rates do move down, you can move before you get to offer. This could be the most bearish looking bond market for property for some time, although there’s no guarantee yields won’t move up further. I’m absolutely definitely NOT a bond trader, although I’d expect this sudden realisation will be absorbed into the system and we’ve found a 5-year trading range, say 2.85% – 3.85%, which might hold for some time. 


If you are sitting NEEDING rates to go down to refinance things – don’t. That’s not going to work. You need to make decisions – pay down debt with capital, refinance and make it work at the new world rates, sell, repurpose/change use class or tenant type. 


That took a bit longer to get off my chest than I expected, but I think it is important to lay out the entire thought process at this time. The bad news is (as it stands today) now really out there – they finally get it, whoever they are – and things will gradually improve from here. Base is still going to be going up though, to be very clear – next meeting is a biggie (how often have I said that, recently!) – will it be 0.25% or 0.5%?


Moving on to some reflection – I had time and cause this week to consider my own evolution as a person. This isn’t about being able to hold my breath for 3 minutes underwater, or developing webbed feet, or anything like that. This is self-improvement and personal development. I reflected over the different stages of my life under which I’ve undertaken formal education at large institutions, and then other stages where I’ve paid for private mentors or coaches, and then other stages where I’ve solely been the master of my own destiny. 


All can work well, and all can work poorly. I certainly wasted at least one of the major opportunities I was given – and then worked to make that right when I was given another opportunity, although over a decade had passed in between the two incidents. I’ve reflected on what drives me, because more and more often, people ask me “What’s the target? What’s the goal?” and I think part of my strength is that that goal is not numerically driven. I’ve never heard them answer the question, but I’ve never even seen anyone ask that question to Warren Buffett (maybe they did 50 years ago, I don’t know). The goal is to keep doing what I’m doing whilst I enjoy it, and whilst it is viable. You could be forgiven for reading the above and questioning whether property investment is indeed still viable, and that would be a mistake (babies and bathwater have already been covered).


There will still be 2 ways to make things work, and the power will be in combining both of them. This is the easiest market by a mile in the past 3 years, and you can buy well. You can also add value. There are so many ways to do those 2 things, there is no point in listing them – even chatGPT would give an insufficient answer, I’m sure. The power will remain in doing both – the deals need to be better because of the market conditions, but that really should be a given.

The real conclusion is that just parking money in property at this time is not the way forwards. The risks are up, if anything, and the premium is down on the past 10+ years. More creativity, more structuring, more asset management, more effort – instead of more risk – THAT’S the evolution that we all need. 


This is the time for more education, as well as more action. Don’t understand something? (e.g. Crypto!) – educate yourself properly, keep your hands in your pocket, be sensible. Never gamble what you can’t afford to lose, either – if you don’t think it is gambling, then see point 1 – go back and re-educate yourself.


One more reflection. Recently, a profitable business I’ve run for the past 7 years has hit a fairly major brick wall. It is not property related – there is no correlation whatsoever. This is very deliberate, of course. A fair amount of money has been lost. Because it is well-managed and fits in well as part of a portfolio, I haven’t noticed that apart from figures on a spreadsheet – but the person I work with closely on this project and I have spent more time on the phone than we have for years.


I’ve enjoyed that. He’s enjoyed that. The final result is something even better, that has been improved, and continues to evolve. It evolves every year anyway, but the extra effort and the extra edge is pretty much guaranteed to pay dividends this year. Back to the “why” part of evolution…..why? Because it is fun. Because I can. I wish that same level of enjoyment, or more, on everyone who takes the time to read this far down the article……I can only sign off with….Keep Calm and Carry On!