As Values Drop, Here’s How To Catch A Falling Knife Without Getting Cut

The most important decision an investor ever makes is the entry price of a deal. If that is right, then whatever happens in terms of timing thereafter will determine the relative success of the deal. But if you are in at the right price, then the dependency on that timing becomes far less relevant as you have bought at a level where you are happy to own, even if your business plan doesn’t materialise as you had anticipated.

The majority of capital today belongs to others. Once raised, if not spent within a time limit, it will have to be returned and so, to a certain extent, the market is full of forced buyers. Ironically, that acts to maintain values somewhat artificially. With inflation eroding cash, how long can a buyer hold back before investors start demanding their money back?

Through several dramatic cycles over nearly 40 years, I sometimes wonder what it is that at some stage in that cycle has convinced me it was a good time to buy. Once I have properly considered the macros, establishing what I would like — or more importantly not like — to buy, then it’s all about individual assets and their pricing. I am an investor of my own money, whether in whole or significant part, and so my decision determines more than just a performance statistic and must alter my decision process.

For most of my career, my initial question is not how much can I make but how much might I lose on a deal, because my default position is I could get the timing wrong and I might need to refinance (I need debt to invest) just at a time when credit markets are closed. So if, in my ‘Armaggedon’ scenario, we can still see our way through to a solvent future for the deal, which will always be nonrecourse funded, then at that point only do we begin to properly appraise the upside.

Underlying rents and values need to be stress tested, but I sense we have a generation of stress testers today who look at 5%-10% as the spread because they have no other experience.

I look at 30%-40% and explore what happens then. Conservatism born of hard and painful personal experience means I buy little, but when I do, I am pretty happy the shock absorbers we have put in place in terms of stress testing the asset and the debt we put around it with very cautious soft loan covenants ensures that the risk profile of the investment is as sound as we can make it. If we can’t make it quite work, then the probability is we won’t buy, or we will seriously limit our capital exposure to that deal.

As to when is that time to buy, the answer is when others are running scared, the investment market is at its weakest, and until you have a very strong sense of the recovery prospects of a particular asset or asset class. In real estate, you don’t often get a chance to shoot the lights out, and that is usually more a function of what markets are doing around us than individual brilliance on a particular deal where real value is created.

Quantitative easing has made many of us disproportionately and unworthily rich and my old mantra of ‘never confuse a bull market with a genius’ reminds me that most make money out of markets, but some possess genuine real estate skills.

Conventional market cycles have been sent out of kilter because of the GFC and QE, and vast fortunes have been made on the back of ownership alone in a negative interest rate environment. That is changing and we are about to experience a rising to the top of the best assets and companies, and a drop in value of pretty well everything else. For genuine property people, this will be a great time to go shopping, but not for the faint-hearted. It’s easy to buy in bull markets, but in the bear ones you need real courage.

I once read that the time to sell is when there is nothing but bright light at the end of the tunnel and the time to buy is when there is nothing but darkness there. That has worked OK for me.

For many investors, property is seen as a safe haven during an economic downturn and the sector has proven resilient in challenging market conditions in the past. However, volatility has given rise to concerns about valuations, leading many investors to wait on the sidelines until there is more certainty.

Our approach is based on identifying long-term structural trends that we believe will deliver value in the coming years. Our current focus is on subsectors such as life sciences, last-mile logistics in central London and high-quality, environmentally compliant assets. We forecast that opportunities will emerge in time. Property investing is a long-term game — resilience and patience are two key characteristics to have during choppy times, and investors should remain disciplined.

There is a general view that the property market is slowing down or on hold for the summer. Whether this is the adage of ‘sell in May and go away' while investors absorb the impact of the Ukraine war, inflation, high interest rates and political uncertainty, or simply the natural inertia that creeps in after a long bull run (and some hot weather) is not important. 

The key consideration is when are the turning points going to occur? The bond and equity markets are good at anticipating market-changing events and pricing this in well before the event happens. But the property sector is far less expert at making these judgments and often overreacts, resulting in mispricing in the short term.

The relevant consideration for investors is when to sell and then when to enter the market to snap up the bargains. For the old-school merchant trader, this decision is largely driven by instinct and gut feeling; for UK institutions, it is a technical matter, probably based on analysis and forecasts in a complex economic model. 

It is interesting to note that in the industrial sector, several portfolios have been put into the market at hot prices, and when they have not sold, have just been quietly removed and retained by the ‘unwilling’ seller. This tells us that the pricing is at or near its peak, but it would be a mistake to interpret this as a fall in industrial values, and it is probably a good thing that some of the heat comes out of the market at this time. 

For the longer-term investor, the decision when to buy or sell should be based on the underlying fundamentals of the property asset class and the individual property’s ability to reflect the characteristics of that sector or subsector. The focus should be on the occupier and their demand for accommodation — whether it is care homes or city offices, the dynamics of occupier requirements will ultimately drive the values. Against this background, some property sectors will still be excellent value even if prices soften in the short term, and trying to call the precise moment the market peaks is a mug’s game. 

So my advice to a generation that has not seen raging inflation, higher interest rates and astronomic energy costs is keep calm and follow the money — i.e. look at who pays the rent and why, and soon there will be opportunities to buy or sell at prices that do not fully reflect the underlying performance potential (good or bad) of the asset.

For sponsors, the linchpin of a resilient investment strategy is always fundamental analysis at the asset and market level. Notwithstanding this analysis, real estate markets are and always have been cyclical, and as such, of equal importance is to ensure you have a durable capital structure, which enables you to ride out the inevitable dips in valuation when they come.

While history tells us that real estate always rises after it falls, no one knows when the fall might come or when the market will rebound. For this reason, investors should, as much as possible, opt for capital structures that enable them to weather the uncertain duration of any downturn, resurfacing with their asset protected and avoiding being a forced seller at the bottom of the market.

As lenders, we naturally build buffers into our loans and use LTV limits to give us the flexibility and insurance to invest in any market. Then it becomes a question of fundamentals at an asset level, which will always apply in any market regardless of underlying conditions: making sure that the asset works effectively in its local market.

Specifically, you should consider how your expected rental and sale prices compare to consumers’ wages and affordability in the area. It is also integral to carefully assess locations where there is likely to be excess demand versus excess supply. In popular cities such as London and Birmingham, the sheer demand for assets over the medium term provides greater comfort that prices will eventually recover, providing some degree of the resilience and flexibility that investors seek.

Many people are saying that they are still looking for opportunities but their behaviour very much suggests they, or their investment committees, are on pause.

We remain open to acquiring tired assets requiring heavy lifting [or] asset management in great locations because the market won’t be on pause forever and we can use the intervening period to work our magic. Often, the countercyclical calls prove to be the best judgment calls.

The shift in market sentiment that we have seen over the last couple of months has resulted in anecdotes of 25-50 basis point yield shifts in some real estate categories, with many transaction processes pausing or resulting in renegotiated pricing. This is mainly due to the higher funding costs related to central banks lifting base rates to tackle inflation, but also as a result of recessionary concerns, more limited debt availability, and difficulties in predicting with confidence future valuation yields.

Essentially, we have moved into more of a ‘risk off’ period where many investors would rather wait and see how markets behave over the summer, with a view to re-engaging in September. The counter to this more uncertain outlook is that, in many sectors, rents are growing in line with inflation — residential, for example, at c. 10% — and there is still strong occupier demand in logistics and other needs-driven areas of the market like student accommodation and nursing homes, where there is limited fit for purpose supply.

It is never easy to predict the future and whilst we are being more prudent in our underwriting at the moment, this could turn out to be a good time to invest — some of the froth has disappeared and there is a little bit less competition. There is, however, still a great deal of capital sitting ready to invest and good quality assets that offer a secure, inflation-linked cash flow are likely to remain of interest to investors. We will continue to target sectors with structural and needs-based demand drivers as we think they will be more resilient going forward.