One of the clichés of real estate investing is that you can make more of everything but you can't make more land. The implication is that real estate has to be a one way bet. More people competing for a share of an asset that can't be expanded very readily must equate to constantly rising prices, or so the law of supply and demand might seem to suggest. The constantly increasing cost of office and residential property in the world's top cities provided an obvious case in point through the 20th century and for much of the first decade of the 21st Century. Before the 2008-2009 global financial crash, investments in commercial and residential property regularly generated year on year total returns of over 15 percent. When both rental income and capital growth were combined, the returns in the more spectacular years could be north of 20%. No wonder real estate caught the attention of investors.
However, what this cliché about the nature of land does not take into account, is that the real estate sector is particularly prone to developing asset price bubbles which go unnoticed in their formative stages. Before the catastrophe of the United States sub-prime mortgage debacle, the loosening of lending criteria for home ownership in the US was justified again and again on the grounds that there had never been a collapse in house prices in the US. Before the crash of the Tokyo stock market property values in Japan had soared to unprecedented heights, with one bedroom flats selling for in excess of the Yen equivalent of a million dollars. China today is desperately trying to craft a soft landing for its economy despite a massive bubble in the Chinese property market. The Spanish economy is floundering largely because its major and minor banks all have massive amounts of underperforming property loans on their books. The Irish Government's efforts at bailing out its banks, which blew up after a decade of disastrous lending on property, left Ireland needing billions in EU bailout funding, and its citizens are now facing a bleak future.
The lesson to be drawn from this is that investing in property is very far from being a safe, one way bet. Property has its attractions and its disadvantages as an asset class. The enduring disadvantage is that by its nature, property is an illiquid asset class with extremely lumpy exits. When you invest in a building you are clearly not thinking of selling it next week, and probably not in the next five to ten years. Property funds do churn their assets, but by comparison with active equity managers, they move in a geological time frame. The long term nature of property investment is well suited to pension funds, which are quite happy to tie money up for a twenty to thirty year time horizon. However, as well as having attractions for institutional investors property has a place in the balanced portfolio of individual investors, particularly where the person concerned is still several years away from retirement. Then too, the fact that commercial property generates a more or less dependable stream of rental income means that it also comes into consideration as a way of building or sustaining income through retirement. Nevertheless, while property might look to a naive investor to be the Holy Grail of investment, able to deliver both income and capital growth, it remains an extremely complex asset class and one that needs to be handled with care, particularly at the present time.
A uniquely difficult set of conditions that are going to persist
The "proceed with care" warning that should accompany any property investment applies through all stages of the economic cycle. However, it is especially true today. Healthy commercial and retail property markets require two things, namely a ready supply of debt financing and a robust economic environment. Neither of these conditions pertains at present in any major Western economy. In its survey of global property trends for 2012, the accountancy firm PwC warns that we are moving into an era for property that is probably going to be a decade or so in duration and that this period "will be characterised by more negatives than positives in its early years."
Among the biggest negatives has to be the fact that as far as lending on property is concerned, there is now a credit crunch that is getting to be as bad as that which followed the collapse of Lehman Brothers in 2008. There are two main reasons for this. The first has to do with the European sovereign debt crisis which had reintroduced fears about counter party risk, since the major European and US banks tend to be highly exposed to the threat of "haircuts" if some of the peripheral countries go down the Greek route and renegotiate their debt. The US banks are not holding that much dodgy European sovereign debt, but they have written themselves into any potential disaster scenario by providing European banks with insurance on their sovereign risks, in the form of Credit Default Swaps. The second reason for the growing credit crunch is that in order to meet the banking regulations laid out in Basel III, banks have to increase their Tier 1 capital ratios by around 9% by June 2012.
Banks can do this in one or both of two ways. They can go to the market and raise additional equity finance, or they can reduce their loan portfolios, since the amount of capital they need is proportionate to the amount of risk on their books. Property lending carries a substantial capital reserve requirement so it makes eminent sense for banks to pull out of commercial property lending, or to make dramatic cuts in the amount that they are prepared to lend.This is extremely bad news for the property markets since it is the equivalent of putting a "deep freeze" on the market. Buyers can't find the funds to buy. Developers can't fund speculative office and warehouse developments. Sellers don't put property on the market because the prices they need can't be achieved, and just about everything grinds to a halt. We are not there yet, it has to be said. There is still a substantial volume of buying and selling going on in core metropolitan markets such as London, Paris and New York. There are "hot spots" such as some Asian emerging markets and Central European markets such as Poland. But the medium term outlook for the sector is far from benign.
Further reading on asset values:
- CEOs Should Refresh Their Finance Skills, by Theo Vermaelen
- Asia: Future Perspectives, by Jim Rogers
- The Credit Crunch Was Like an Atomic Bomb; It Will Profoundly Change How We Think and Behave, by William Hopper
 PwC Emerging Trends in Real Estate: Europe 2012, p. 4 (This report can be downloaded for free here)
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