British Malaysian Chamber of Commerce – Don’t Sweat The Debt

Borrowers and lenders aren’t pushing property yields down, investors are being driven to real estate by external factors.

It was fascinating to see the market commentary over the summer as professionals pondered whether it was worth leaving their poolside lounger to come back to work or whether we were all doomed.

An article in Estates Gazette written by Richard Dakin, Managing Director CBRE Capital Advisors particularly caught my attention. Richard approached the question of doom from an economic perspective, concluding that “I am struggling to see why we should not remain more positive about the prospects for the real estate market in the short to medium term” and reading between the lines was a tone of…”It doesn’t feel like the top of the market to me”.

As Richard has covered the economic indicators, I thought I’d see what clues the debt market could provide, particularly as it was its exuberance in the previous cycle that whilst not the primary cause of the crash, certainly acted as a catalyst to the speed and the pain of the fall.

Ever since the market bottomed out in the Summer of 2009, I’ve been asked the same question by investors: “But what happens when interest rates rise?”. My response in recent years has been to point out that rates aren’t rising they’re actually falling, as the vast majority of purchasers don’t float their interest rate, but fix for a three to five year term. Such interest rate swaps have been falling, with such swaps roughly half the level they were six years ago.

Borrowers have also been extremely cautious in my experience. It’s taken a long time to ease our institutional purchasers above a 60% loan to value. This is where they were comfortable, and still now they would prefer 62.5% to 65.0%. It really is that sensitive an issue.

Meanwhile, lenders have also remained sane. Margins are still “reassuringly expensive” in the 150-200 basis point range and at least double what they were during the crazy days leading up to the Summer of 2007 when the music stopped.

Such sanity is being encouraged by the Bank of England. I recently heard their Executive Director for Financial Stability Strategy and Risk, Alex Brazier, speak at a property dinner about the stress tests that they are having the banks run, the multiple times more capital the banks are now required to have and a new benchmark that banks will be required to report on, which sounded very similar to the debt yield calculation we are familiar with from our US operations. The sustainable long term net income from a property is divided by the loan amount. Less than say 10% is a problem, greater than that is safe.

So, if debt isn’t to blame for driving property yields lower, what is? In my mind, a lack of attractive alternatives and a global recovery that is slowing down.

The low or no return on bank deposits is well documented, so what else is an investor to do? Equity markets remain volatile. Bonds maybe? Better yield than your bank deposits, but no real prospect of an upside. Gold? Down more than 10% over the last 12 months and of course doesn’t provide an income.

Meanwhile, I believe that there is a slow realisation that the world is spinning somewhat slower these days. The OECD has cut its global forecast for GDP growth to 3.0% for this year, the value of merchandise traded around the world has fallen 13% compared to the first 6 months of last year and there is even talk of interest rates being cut in the “noflation” economy as it is today.

In this context, why wouldn’t you buy a quality building, with a long lease to an investment grade tenant and be happy with a 5% (or perhaps even lower?) yield and the ability to bolt on some modest leverage?

Top of the market? Not from my perspective. Ask me again when bank margins are below 1%.

 

Article from BMCC