Supplement 260323 – checkmate

Mar 26, 2023

“The creative combination lays bare the presumption of a lie; the merciless fact, culminating in a checkmate, contradicts the hypocrite.” – Emanuel Lasker, German chess player


Welcome to the supplement – as we enter week 2 of the banking crisis, which is not really a crisis, or is it? We seem to see that word used once a day at least at the moment, and if nothing else, we are badly in need of new nouns – or at least more appropriate ones. This week will be a refresher and explainer of why the Bank of England did what they did this week and raised rates to 4.25%, and the abyss that faces them ahead. If this isn’t checkmate, there aren’t many more moves, and the vast preference of all concerned would instead be a stalemate, rather than a game-ender. Let’s hope it has all been a game-changer, instead of a game-ender!


After we get through the macro, I’ll move on to the micro and just where this leaves the market, likely deal flow over the next quarter or so, and a few ideas for transacting in this difficult environment! I also want to share a really challenging couple of conversations I’ve had this week, for everyone’s benefit. One pledge – it is shorter than last week, so stay tuned….


Since last week, we’ve seen the downfall (or at the very least, hostile takeover) of Credit Suisse. This is a significant event, but stinks of the old adage “never waste a good crisis”. My personal feeling is that the Swiss National Bank has wanted to clean up the multiple sins of Credit Suisse and the best way to bolster confidence in the entire system was to get the largest bank in Switzerland (UBS) to take over the second-largest. Quite a behemoth has been formed…..and there is a limited amount this has to do with the collapse of SVB that was detailed last week.


This is less contagion and more opportunism. The punishment of CS for recent bad behaviour, rife with scandals in the past couple of years, is complete. The technical significance of the complete loss of AT1s – Additional Tier 1 capital bonds – is something that we will see play out in the courts in the next months and years. Effectively – although this is allowed in the small print – we’ve seen common stockholders be prioritised over bondholders – at the very least, the argument at the base level will be that “bonds” was not the right description for AT1s if they were to be below equity in the capital stack in certain circumstances. This particular (technical) use of the contingent convertible bonds (cocos) known as AT1s here is not necessarily putting the entire £250 billion european AT1 bond market at risk – the Swiss terms were particularly punitive so that at least on paper, what happened was a legitimate strategy. The question will be, at the very least, why write down the bonds altogether but still let stockholders receive some return?


Since then, we’ve seen Deutsche Bank following suit, with some wobbles and on the last day of trading this week a real nosedive before a recovery. This still feels like cleaning house – Deutsche, like CS, has been embroiled in several scandals over the past years, and is also a massive name in a country with a strong banking reputation. Somewhat different, however, is that Deutsche is by some way the largest bank in Germany, and the second largest bank is DZ Bank – not the household name you might expect. Deutsche has nowhere near endured the horrific financial performance that CS has over the past years, and I doubt the ire of the Bundesbank towards Deutsche compared to that of the Swiss National Bank over the Credit Suisse situation. 


This left the Bank of England with a tough decision, since, as highlighted last week, all this continued to play out around the Bank meeting around interest rates. The whole quandary was made quite a bit easier this week however, when we had an inflation print that surprised (nearly) everyone. The consensus was below 10% – but instead we hit a 10.4% number. Half a percent above consensus, which is really significant. This resultant shock meant that once again, 7 members of the Bank’s Monetary Policy Committee voted to raise rates once more, by 0.25%. The same 2 dissenting voices – those who think we’ve gone far enough, and risk egg on face by having to put rates down, voted against – the same two who have been doing this since we hit 3% base. 


The bond and swap markets, as a result of all of these pieces of information and a few more, were predictably all over the place this week. The current premium of the 5y swap above the gilt yield is nearly 40 basis points, which is a significant premium – simply because of the volatility. It still remains around 3.5% for the SONIA swap, however, and 3.12% for the 5 year gilt. This translates to mortgage rates around 6% cost (including arrangement fees) – or rates of around 5-5.5%, if the pay rate is what you prefer to watch rather than the true cost of the debt (it is the pay rate that defines your interest coverage ratio, so, it is understandable why everyone prefers it, but it is inaccurate to forecast based solely on the pay rate, because arrangement fees will compound the slice they take out of your pie, over time). 


The bets have gone in that rates will need to come down sooner rather than later. A few sharp and savvy friends of mine are in that camp – worth a bet that rates will come down. I’m so focused on just how strong and long inflation will remain, however, that I can see that even in the event of a recession (black swans aside) we might still be hiking rates and dealing with high inflation at the start, rather than cutting rates immediately. So this isn’t a reflection of a market that SHOULD have bond yields set at 3.12% on the 5 year, but a market that has a large number of participants who think the yield should be higher than that, and a small number of participants who are willing to bet that that yield might go down to 1% or even zero (or even negative!) within the relatively near-term. 


This is a bet on a black swan bet of significance. Such a large event that the central bank and government together cannot contain it, and need to let it rip, get rates to zero and print a significant amount of money. Something that destroys demand and nearly zeroes inflation. By the end of this year – from over 10% – this would be without historical precedent by some way. Typically, even with poorly-managed economic crises, it has been at least 18 months to get inflation back to any sort of controllable level from this sort of peak (if, indeed, we’ve even seen the peak yet…..) – and that’s why I’m against this run-out of events. There is the argument that we are at a falsely high level due to the supply shocks in the economy post-covid, although those base effects only have a few months left to play out, in honesty.


Put it another way – if those betting on these outcomes are correct, we are in very bad shape at a macro level. Low probability with a very high payoff – the very nature of “long-shot” betting.


So – the hike continues, but loses pace. We have another 6 weeks until the next meeting, at which point we will know a lot more about the banking state of play, apart from anything else. At the moment this doesn’t look like the last hike – but each extra 25 bps heaps extra pain on banks and pension funds who are holding a lot of bonds at 2020/2021 prices, which are trading way under that at the moment. Bizarrely, however, the crisis has helped them out, since the prices have come back up a bit and the yields gone down…….how’s that for a virtuous circle?


Back in the real world of property, this has also of course heaped extra pain on those who are on “base + margin” products. Pain unseen since February 2009, in fact – when many might well still have been in the fixed period of their products. Base + 1.7% – which is about the best rate many are on on the old mortgage express products (and their successors) – now weighs in at 5.95%. If you are a typical legacy landlord, your rents might be 5-10 years out of date or 25%+ below the market rent, and your property that perhaps should yield 7-8% is actually only achieving 5.5-6%, and with leverage at this price, you are “gearing down”. I’m going to spend a bit of time on this, because that’s much more dangerous than most people give it credit for.


There’s a narrative that’s pushed by the guru side of the training industry. “Good debt, bad debt”. There’s absolutely elements of truth to this, but like always, a little bit of knowledge is a bad thing. It tends to be framed by the channel, or the type, of the debt. I.e. Mortgage good because secured against an asset, credit card bad because unsecured. But as always the devil lives in the detail. 0% Credit card, with 48 months interest-free in a time of ravaging inflation, used to purchase building materials for multiple refurbs – with liquidity in the bank to cover the bill anyway? That’s genius leverage, NOT bad debt. 


Likewise – if your mortgage rate (or, to be a stickler, the actual cost of the funds) is above your yield after management/running costs on a property, that’s likely bad debt rather than good debt. You wouldn’t BUY a property at a 5% yield and take a 6% mortgage on it (it should be self-evident that you can’t take a 75% LTV mortgage here, but you could take a lower LTV mortgage), so why would you remortgage one? Because you are stuck in a relatively bad spot, that’s why.


What’s the maths behind this? Well, the key metric here is return on equity. Investors (and companies) use debt in order to gain sensible leverage. If a property yields 6% after running costs, and the cost of debt is 3% (remember those days?), and you take a 75% mortgage, your return on equity (ROE) is going to go from 6% (unencumbered, not considering capital growth) to 15%. If a property yields 5% instead, and the mortgage rate is 6%, the max leverage allowed will be 66.66% thanks to interest coverage rules, and your ROE is going to go from 6% down to 3%. This is a horrible spot unless you have a near-guarantee that capital growth is going to be significantly intense in the near-term – and if there are concerns about the prices moving downwards instead thanks to a high interest rate, you have more money at risk than in the first spot, at a lower return. This is gearing down, and should be avoided wherever possible (of course, you also need to consider everything else – for example, if there is a massive tax bill triggered by selling the property, you should instead be looking at return on realisable equity, rather than the raw return on equity – I much prefer RORE here to ROE as a rule, but I’m in danger of overcomplicating things… usual I hear you say).


So – beware of gearing down. Never say never, but appreciate the risk being taken. If you have to gear down to buy another deal that is exceptional, you can of course justify it – but just be aware of the risk and the total costs. 


Let’s sit on the other side of the fence for a minute then. There’s potentially a LOT of landlords out there with “old” pre-2008 debt, still in their personal name so section 24 is absolutely crushing them (because the situation is WORSE than the above, their debt is not necessarily fully expensed against their revenue remember), who are facing their highest mortgage rate thus far, and are being forced into gearing down without even understanding what gearing down is. If their finger is not on the pulse, they won’t realise this until January 2025, when they file their 23-24 tax return for the tax year about to start, which is going to have the most punishing regime for personal name investors thus far. However, what even the most sleepy will notice is the punishment to their cashflow.

Those who are at least somewhat in touch with the business side of their portfolio will be noticing their bank balances already, and will have been for the past 9 months or so. That cash buffer that existed every month is evaporating, and is very likely now to have turned negative. Ugly stuff. So what…….well, there is a really strong incentive to sell right now. Whereas a few weeks ago this looked like a last hike, or a last but one – or perhaps even a “no change” – the current landscape hinges massively on the next inflation print (and April’s is likely to be an ugly one, I don’t have a particularly strong view on March although the more inclement weather than usual might have slowed spending down a little), which comes out before the next Bank of England decision. So that feeling that’s there for the less informed is likely to be “when will this end?”.


If people have not been taking action and have their heads in the sand, then the likely result is that distress will happen quickly and severely, and fast sales will be needed. Auction stocks are likely to go up – direct to vendor leads also. The big one of the 3 Ds (Death, Debt, Divorce) – Debt – is back, and it is back with a vengeance (it took a major league sabbatical during Covid times). 


If there are those out there thinking that they can tough it out – the only major drop in rates happens on the back of a very bad economic event which causes other problems, such as the ability to pay/afford rents, which won’t fix too much (or will give with one hand and take with the other). Every single property needs assessing for its return on realisable equity – portfolio landlords take note, if you are not tracking that month on month (or at least quarter on quarter), you want to be!


Things are going to need to be cheap, and also have some yield, to make investment grade in this environment. You can certainly look at the cash-on-cash return rather than the yield (net of running costs) – and be patient. That’s what we are doing on several of our current purchases – we are buying solid equity that will protect us even in a downturn, and can wait for the cashflow expecting meaningful rent rises over the next few years. Patient capital (and cashflow) uplifts. The others are largely characterised by being solid cash flowing assets and/or businesses that should be robust during a recession or downturn.


The distressed market has been teetering on the edge for at least 18 months now, and could be about to ramp up again (the increase has already been massive since the start of this year, but there are base effects of Covid thanks to stimulus as already discussed). 


I wanted to finish off this week by sharing my experience from a conversation that came from a networking meeting. I had presented about the current state of play in the market, and also my own personal experiences garnered from building up a portfolio. An individual approached me in the break, afterwards, who clearly knew what he was talking about – that much was very self-evident. He also (of course) saw a business opportunity for himself. 


We arranged a call after a 10-minute chat that was very rich in high-level ideas, to do with “next steps” for my investment group. That chat was then absolutely fascinating, because it had elements of psychology, coaching, reverse psychology, hypocrisy at some stages and straightforward disagreement also. I’m pretty broad shouldered and tough to upset, but the brutality of the conversation did nearly elicit a few reactions from me. 


The conversation centred on whether I should attempt to float my property group – to move towards an initial public offering (IPO) on a secondary market (something like AIM, for those in the know). He poked and prodded hard on whether I “wanted it enough” (his framing), and then proceeded to make some hilarious (and I’m pleased to say, 80% incorrect) assumptions about my current position, my lifestyle, my age, what I do with the money, etc. etc. – whilst also marginalising what I have achieved thus far.

Was my ego dented somewhat by this? I think I’d have to concede that it was, temporarily at least. However, I reframed the conversation and took the positives out of it. It pushed my thinking really hard, and questioned whether I have had the correct approach, and whether I do today. I told him I’d sleep on his proposal and take it forward from there, and we arranged to speak in another week or so.


Then, I slept on it. I remembered exactly why I’d chosen not to follow a vanilla, corporate career path. This offering was simply going to make lots of money for other people (I’ve no issue with that – I’ve done a lot of it over the years) – but for more work, a different structure, pressure that I wouldn’t enjoy (perhaps equal, or less pressure than I already put myself under – but when it is out of choice, it feels very different of course). A lot of the structure he assumed that I didn’t already have in place (which actually I do, happily) was a good idea, so I was very pleased to get that level of validation from someone who, as I say, very clearly knew what he was talking about.


I was then fortunate to have another great conversation at our Partners in Property meeting in Bristol on Friday. Portfolio landlord in a strong position, but still unincorporated and mithering over the embarrassment of choices out there to incorporate – if you are in the same position I do understand, it is a minefield and beware the best sales people who have form for “schemes” that are nowhere to be seen when they fall apart. Some really interesting knowledge was shared about various structures that are apparently being looked at for not being HMRC compliant. I couldn’t recommend Rod’s Rodcast enough on this topic – episodes 22 and 24 – get stuck into them. Rod has one of the very top tax barristers in the country on, who really understands the law, rather than someone who just reads the HMRC manuals and tries to find loopholes, mostly based on their personal opinion (that approach is always insufficient, just so you know, alongside its incredible arrogance!)


The solution there (post-incorporation), particularly in a higher corporation tax environment (and if Labour are elected, will that go up or down….you decide), might well be to look at a REIT (real estate investment trust). This depends of course on portfolio size, but might well be viable for those who are looking solely to extract income and aren’t really interested in growing the portfolio. For those growing and willing to go through scaling pains, particularly if they are doing so at a relative pace as my group has done, the limited company likely remains the best option, but everyone’s circumstances are different, so please make sure to canvas opinion from those who are NOT incentivized by the massive fees they will be extracting from you, and make a sensible and informed decision.

The landlord in question was advised by a very sharp friend of hers to assemble a decent tax planner who understands property, and a great lawyer, and get on with the incorporation process – not a “social media hero” who talks a great game but never delivers, or is happy to plug any gaps with best guesses rather than know the answers. I think that’s great advice, and indeed that’s exactly the advice a tax planner gave when I was running through a completely different scenario (to do with inheritance tax) on the way back from the meeting – I’d come up with a creative solution to a £400k+ looming IHT bill, and the answer was “maybe” (rather than no) – it isn’t my £400k+ problem but I’m always interested in trying to solve these of course. I missed my calling as a tax planner…..maybe……although I’m quite happy where I am, which is back to where this part of the story started!


I had a conversation about business coaching this week which was very interesting, and the person I was talking to shared some of the same feelings which helped me to frame exactly how I felt – “Get Comfortable being Uncomfortable” was one I first heard from John Paul, Lettings and Estate Agency mogul from the North East. It’s a great saying. It’s a bit like the gym though – some element of soreness tells you that the muscles have been worked hard and are healing, but if you feel like that every hour of every day you are overtraining and not doing yourself any good. To translate into business coaching, mentoring or whatever you want to call it – those questions and feelings of inadequacy or similar that can be stoked by such conversations have a use and a purpose if you frame them correctly, but having them all the time will never be good for your psyche overall. Have them sparingly, and most importantly – DO THE WORK! That will suffice for this week – keep calm, and carry on……