Is the Hong Kong property market about to crash?
“Peter, is there going to be another property crash in Hong Kong?” I get asked this question often. It’s understandable. Many people are worried the> READ MORE
“Peter, is there going to be another property crash in Hong Kong?” I get asked this question often. It’s understandable. Many people are worried the> READ MORE
Right up until his death in 2016, Cheng Yu-tung was a true lion of Asian business… Typical of many Chinese billionaires, his success came from humble beginnings.> READ MORE
Right now, there’s an anomaly in certain real estate stocks in Asia… The anomaly is the share prices of these companies in relation to their underlying net> READ MORE
It's one of the greatest transformations the world has ever seen... In 1965, the small island nation of Singapore was in bad shape. It had few natural resources,> READ MORE
These days, you rarely hear anyone mention European real estate securities. And they’re certainly not on the radar here in Asia. Within the global listed> READ MORE
I recently showed you three ways emotions can cost you big in real estate investing. To start off the new year… today, I’m revealing three more emotional> READ MORE
(A very happy new year to our readers… and a profitable 2018!) Right now, you could be making several dangerous investing mistakes… and you likely don’t even> READ MORE
If you want to profit from real estate stocks, there’s one important thing you need to know… Not all listed real estate stocks are the same. If you want to> READ MORE
“Peter, is there going to be another property crash in Hong Kong?”
I get asked this question often. It’s understandable. Many people are worried the residential property market in Hong Kong is overheating. And it has certainly gone up. It saw a compound annual growth rate of 7.4 percent from 1981 to the end 2016.
So is the Hong Kong residential property market a true bubble? Will current conditions lead to a crash in the housing market? And is there real systemic risk to the banking system?
The answer to all three questions is NO – not at this stage…
Property bubbles and the systemic risk they bring are usually created by excessive debt being piled into real estate, both by developers and property companies and also end users.
So let’s first take the residential property developer community in Hong Kong.
The Hong Kong housing market is dominated by about eight or nine major developers of private housing. These companies do not carry a lot of debt. They are not Chinese companies or U.S., UK, Australian or Canadian developers that typically have net debt to equity ratios of around 50 percent or more.
No, the average net debt to equity ratio for the major listed developers in Hong Kong is typically in the 15 percent to 20 percent range, with many well below this level. The real estate developer sector in Hong Kong is by far the most lowly geared of any country around the developed world.
They have learned the lessons the hard way, from bitter experience back in the 1980s. At that time, Hong Kong developers had splurged on debt and a massive building boom. Prices went up approximately 100 percent per annum for the three years leading into 1981. That was a real estate bubble of epic proportions. At the time, I predicted to my clients that I thought Hong Kong would experience a correction of at least 10 percent in its bloated housing market. I was way wrong. The “correction” was more like 70 percent over three years. That was a time when I watched these companies hanging on by their fingernails – and the good graces of HSBC and other local banks.
Since that near-death experience, these companies have shunned debt. For example, one of the larger-listed companies whose board I sit on routinely runs a balance sheet which has a net debt to equity ratio between 3 percent and 5 percent. That is miniscule!
So there is no real systemic risk to the financial system from the big players in the real estate development game in Hong Kong.
But what about consumers? Well, unlike many other developed countries, Hong Kong folks don’t carry a lot of credit card debt. They are not big users of hire purchase loans and loans to finance buying household goods and the like. They do not have a system of college education debt – a problem that is engulfing families in the U.S. They also do not carry a lot of auto loans.
The biggest debt for most Hong Kong consumers is likely to be a mortgage on an apartment.
Today, the average new mortgage loan granted is for 51 percent of the value of the property, down from 64 percent back in 2009, when the market first started to recover from the global financial crisis.
That low LTV (loan to value ratio) gives banks a very sizable equity cushion.
This means that anyone taking out a mortgage from a bank today would need to see the value of their home fall by 49 percent before they got into a negative equity position. That is, their outstanding mortgage debt would be more than the value of the property.
And delinquent mortgage loans in Hong Kong represent just 0.04 percent of all mortgage loans. That is less than one tenth of one percent. That’s about as close to zero as one can get.
Now, we have seen big falls in Hong Kong residential property in the past. For example, when residential property fell by around 60 percent following the Asian financial crisis in 1997.
By September 2003, the Hong Kong Monetary Authority estimated that 99,805 residential mortgages were in negative equity. This represented 20 percent of all residential mortgages outstanding. Given that prices had fallen some 60 percent by that time, I was surprised that the figure was not higher.
And did people default on mortgages? Very little. Delinquent mortgages (the proportion of residential loans overdue by three months or more) peaked in June 2003 at a very small 1.12 percent. That was hardly likely to blow the banks apart. So if history is any guide, any property market downturn today would probably not result in a big default rate.
In short, it seems there is little systemic financial risk to the banking system in Hong Kong coming from either the developer community or the end users in the mortgage markets.
So why don’t I think the Hong Kong property market is a bubble that will burst with terrible consequences?
A bubble occurs when activity and pricing in a particular asset class (stocks, bonds, real estate, art) becomes manic and soars beyond long-term average levels and rates. I am referring to two variables here. Volumes of transactions/activity and prices of the assets in question.
The China stock market, for example, was very clearly in a bubble in its huge run up in 2014/2015. Both pricing of the market and trading activity soared way beyond longer-term averages. The Shanghai market, for example, rose 153 percent from the end of May 2014 to its peak in the second week of June 2015. Stocks were trading at valuations way in excess of “normal” levels. Stocks that normally might trade at a price-to-earnings ratio of 15 to 20 were then trading at 50 times earnings. And daily volumes of share trading soared by many multiples of “normal” levels.
So let’s take a look at the Hong Kong residential property market. Our chart below shows the long-term volume of property transactions (the number of residential sales and purchase agreements) in Hong Kong.
The average monthly trading volume is in the range of 6,000 to 8,000 per month. A sustained volume of transactions above 10,000 per month is usually a sign of bubble conditions. Levels consistently below 5,000 are signs of a bear market.
Early 2016 was an extremely bearish time, according to this indicator. Transactions volume fell to record low levels of less than 3,000. Volumes picked up, but were at very low levels again as recently as January 2017. For the first eleven months of 2017 the average monthly residential transactions volume in the primary and secondary markets was 7,049, well within the “normal” range.
So there is no manic bubble being reflected in the volume of transactions.
Hong Kong’s housing market is probably the most volatile in the world… certainly amongst developed markets.
Since 1997, the Hong Kong residential property market has had five meaningful corrections (or pullbacks). There was a period in 2005/2006 where the market flat-lined. But the biggest tumble was a jaw dropping 60 percent fall during the Asian financial crisis between 1997 and mid-2003.
The most recent correction was in Q4 2015 to the end of Q1 2016. Prices fell about 13 percent. But the market was quick to recover, and by the end of 2016, it had recovered all its losses from that correction. The residential property price index now stands about 7 percent higher than it did at its previous peak in Q3 2015.
At the current “run rate”, Hong Kong’s housing prices were set to produce a gain of around 15 to 17 percent last year.
Following it’s decline in 2015/2016, a price increase of this level is certainly substantial, but it does not qualify as a manic boom.
There simply is not the mania that normally accompanies bubbles that burst. It’s not there in buying activity and transactions volumes. It is certainly a buoyant market, especially in the primary market where developers are offering buyers top up financing over and above what the banks are providing. That is stimulating the primary market. That kind of financing is not available in the secondary market, so there is reduced activity in this part of the market. Buyers can typically obtain only a 50 percent mortgage.
And there is not a debt-infused bomb that is about to go off in Hong Kong, either with banks, developers, or households.
There is also no massive supply bubble that is going to hit the market and force prices down. In fact, supply coming on line over the coming three years or so will be about 20 percent to 35 percent lower than the average supply in the 30 years leading up to 2003. Supply is modest, but rising slowly.
Finally, there is not an inflation bubble on the immediate horizon in the U.S., which would signal a big rise in interest rates in Hong Kong. Yes, interest rates are set to rise, but will still be much lower than longer term averages.
In short, I just do not see conditions that would produce the sort of huge 60 percent down side that followed the 1997 Asian financial crisis.
To sum up, I don’t see any systemic risk to the banking system or any signs of a residential real estate bubble in Hong Kong.
Right up until his death in 2016, Cheng Yu-tung was a true lion of Asian business…
Typical of many Chinese billionaires, his success came from humble beginnings. He started in the jewellery business in Macau in the late 1930s. He later inherited and grew the family business.
From there he moved, like so many of his generation, into property in Hong Kong, in the 1960s.
Forget diamonds and gold… real estate is where real money was made.
Cheng Yu-tung was a highly regarded businessman who extended his reach beyond property and jewellery into infrastructure, retail and hotels.
His core company was New World Development (Exchange: Hong Kong; ticker: 17). His jewellery company was Chow Tai Fook (Exchange: Hong Kong; ticker: 1929) for more than 30 years.
In my investment banking days, I was part of the team that took New World’s China property business public. It was one of the earlier China property sector IPOs.
New World was a pioneer, showing how foreign companies could take on China’s fledgling property markets in a big way.
Asian property investors and developers have often struggled when entering foreign markets, but one example of a “win” involved the Cheng family and a fellow Hong Kong tycoon, Vincent Lo, another property tycoon with big real estate interests in Hong Kong and China… and, as it would happen, an American developer named Donald Trump.
This particular deal initially dates back to the 1970s. But it really took shape in the mid-1980s. It involved the Manhattan West Side Yards, a 77-acre site on Manhattan’s west side.
The owners went into bankruptcy and the site fell into the hands of banks. Trump’s role in this began in 1985, when he acquired the Yards from another distressed developer for US$115 million.
Given Trump’s frequent incursions into bankruptcy and financial distress, it’s not surprising that it didn’t take long for this asset would fall into the “distressed” bucket again.
In the early 1990s, the site, under Trump’s control, was bleeding cash. The New York property market was undergoing a correction at the time, which didn’t help.
Trump’s bankers forced him to relinquish control of the site.
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The new owners? The Cheng family and Vincent Lo.
In 1994 they paid US$82 million, and assumed the roughly US$250 million debt that Trump had accumulated.
The new owners set about developing the site with up-market condos and other uses. Trump was entitled to a share of the profits from property sales, and took management and construction fees during the build.
In 2005, the Hong Kong team agreed to sell the development for around US$1.76 billion.
And that’s when Trump screamed blue murder.
The case ended up in the courts.
Trump tried to sue the pants off the Hong Kong partners. His argument? They should never have sold it for that price. It was worth much more, he contended.
He refused to accept his share of the proceeds of the sale.
Over the next four years, the case dragged on, producing 166,000 pages of documents for the court.
Trump accused his Hong Kong “partners” of all sorts of infringements… from tax evasion to fraud.
His compensation was a minority interest in the New York and San Francisco Bank of America Buildings (which were recently worth around US$640 million, according to Bloomberg).
Trump of course has since said that this was a great deal… and that he won! One of those times he “beat China”…
One lesson? This illuminates the character of the U.S. president, for one thing. More broadly, though, this story demonstrates the importance of retaining control over investments where possible.
Trump was a minority shareholder in the project and couldn’t drive it as he wanted. Despite having his name on the buildings, he was a passenger.
Whenever possible, don’t be a passenger… it’s your money.
Right now, there’s an anomaly in certain real estate stocks in Asia…
The anomaly is the share prices of these companies in relation to their underlying net asset value (NAV).
You see, in many parts of the region, shares of real estate companies trade at a substantial discount to their underlying NAV.
This means that an investor in these shares is buying US$100 worth of property assets for, say, US$60 (that is, a 40 percent discount to NAV).
You cannot buy bricks and mortar assets at discounts like this. No one says, the market value of this building is $1 million, but I’ll sell it to you for $600,000. So it’s no surprise that investors are interested in this proposition.
But before you jump into real estate stocks trading below their NAV, you need to consider whether these stocks are actually a good deal…
In simple terms, NAV is the value of the company’s assets (the value of the real estate, plus any other businesses that the company may hold), less the debt and other liabilities that are owed by the company.
Under accounting rules, all investment properties (properties held in the portfolio for rental income) should be revalued each year with the new valuation reflected in the company’s accounts. This takes into account any increases or declines in property values over the course of the past year.
But properties that are under development do not need to be revalued. They are held on the books at cost (which normally includes land cost and any construction costs already incurred), or at a figure reflecting realisable value, whichever is lower.
In most cases, the value of the completed development properties is likely to be considerably higher than the values held in the accounts. Hence, the reported book value of the company will likely underestimate the full realisable value of the portfolio of development properties.
For real estate investment trusts (REITs) and investment property companies that don’t have many development properties, the stated book value is likely to be a much closer measure of underlying NAV, if those investment properties are revalued each year.
Why aren’t investors prepared to pay to pay a price for Asian real estate shares that reflect the underlying value of the company’s assets?
There are several reasons:
First, there may be a difference between REITs and other types of property companies, such as developers. REITs often trade at prices much closer to NAV and sometimes in excess of NAV. That may be because of the stable nature of the company’s portfolio and its income. The rules that govern REITs mean that they must pay 90 percent of income to shareholders as dividends. And the amount of more uncertain, risky development that REITs can do is often limited by the rules. Sometimes debt limits are also imposed, and in most cases, REITs attract certain tax benefits that other companies don’t get.
Developers take bigger risks simply because they buy land, often expensive, up front, and spend years developing it. The pricing of the finished product at the end of the development period is uncertain. This is especially the case in volatile markets like Hong Kong, China and some other parts of Asia. The returns on investment may be very good, but the rewards are normally achieved at greater risk.
In short, REITs often enjoy lower volatility than the market as a whole and lower volatility than developer stocks.
So they are perceived as carrying lower risk and therefore less uncertainty. Investors pay a higher price for that lower perceived risk.
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Then there’s the “management discount factor.” You see, many listed real estate companies in Asia, especially Hong Kong, are controlled by family groups that have maintained a vice-like grip on the company, sometimes for generations. Investors sometimes believe that the controlling shareholders are really running the company for their own benefit and not for the benefit of shareholders. In short, investors feel that they’re not focused on creating shareholder value.
For example, a company I have followed for many years owns a portfolio of high-end hotels. The family patriarch who controls the company is a keen helicopter pilot. The company has spent large amounts of money (shareholder money) building helicopter landing pads on the top of some of its hotels. This can in no way be profitable for the company, and some investors think this is done to satisfy the controlling shareholder’s private hobby.
There have also been examples of changes in family management that has brought radical changes in tactics, strategy, gearing and risk taking.
For example, many years ago, the son of a company founder took over the reins of the company from his father. The son immediately cranked up the debt and embarked on a splurge of asset buying in various markets around the world. Shareholders were not impressed, and the company has consistently traded at a discount to its peers pretty much ever since.
And then there are transparency and policy risks that investors will often take into account. For example, China-based listed companies are widely believed to have lower corporate governance standards than those in more developed, longer established markets. Disclosure and transparency in Chinese companies is often much less than it is for companies elsewhere. These companies are having to learn what is expected of them when they enter international markets.
Government policy is another big factor in some countries, and certainly in China. The authorities exercise huge control over most aspects of the economy and financial conditions in China. This is not a free market in the way that most western people think of markets. The Chinese government is constantly tweaking the rules and pulling lots of levers to control and direct companies, their businesses and financial outcomes. The real estate sector is a classic case in point. New rules seem to emerge onto the stage on a weekly basis.
This all places a climate of uncertainty and risk on companies. Investors know that the companies can be hit with any number of new rules, regulations or requirements at any time. Share prices often reflect that risk and uncertainty.
Now, in some circumstances, real estate stocks may trade at a premium to NAV. This can happen if the market believes that real estate values and rentals are set to rise in the future and the NAV will expand. Investors may reflect that into share prices now.
Some REITs may also often trade at premiums to NAV. This can reflect a view that valuations, as given in the company’s accounts, are below what could realistically be achieved in the open market if assets were to be sold.
It’s all well and good to say that a certain stock (or market) is cheap because it is trading at, say, a 50 percent discount to its NAV.
But before we jump to that conclusion it is worth quickly checking the following:
I know investors who have bought a particular stock because it is trading at, say, a 55 percent discount to NAV. But sometimes that stock has traded at around this valuation for many years. So relative to its own history, it is not cheap.
Then the question becomes, “Is there a catalyst that is likely to make this stock trade closer to its NAV?”
For example, some investors look at Chinese property stocks, many of which were up at least 30 percent in 2017, and conclude that they must be expensive. But, in fact, the sector as a whole is trading at a discount to NAV of around 33 percent. That’s been about the average for the past 12 years.
But listed property companies have been enjoying record sales and strong sales growth in the past year. Those sales will reflect in earnings in the coming year or two. So given that the stocks are not overly expensive relative to their historical NAV, the strong earnings growth can also help underpin share prices.
Similarly, Hong Kong real estate stocks were up around 30 percent in 2017. But the property companies (not including the REITs) are still trading at a discount of close to 40 percent to their NAV. Companies that have sometimes traded at prices close to NAV are now trading at 40 percent to 50 percent discounts. And these are big blue chip, bellwether stocks in the sector. So despite having risen strongly, share prices are not expensive against their history on a NAV basis.
For Singapore, where a greater proportion of listed real estate companies are REITs— which often trade at higher valuations than property developers – the picture is very different. Here, property stocks are trading, on average, at a premium to longer-term averages and at a premium to underlying NAV. Therefore, they appear more expensive.
However, the Singapore real estate market is crawling out of a trough where property prices fell over the previous three years. Property prices are starting to recover, which will likely push NAVs higher in the coming year. Stocks have reflected that expectation to some extent already.
So as investors, we should always look at the relative valuation of individual property stocks or the overall sector (relative to its own history and its peers) and try to understand the catalysts for why the current situation exists. Then we can understand what might make it change going forward… and whether or not we should invest.
It’s one of the greatest transformations the world has ever seen…
In 1965, the small island nation of Singapore was in bad shape. It had few natural resources, double-digit unemployment and an uneducated population. At just 275 square miles (a third the size of Greater London and four-fifths the size of the U.S. city of San Diego), it was one of the smallest countries in the world. Aside from its location in the middle of the major sea route between India and China, Singapore didn’t have a lot going for it.
Fast forward to today, and Singapore is one the most prosperous, innovative and well-developed countries in the world.
It’s also one of the wealthiest. Its GDP per capita has grown more than 10,000 percent over the past 50 years, and today stands at US$53,000 per capita. That compares to US$57,000 per capita for the U.S., and US$8,000 per capita for China. Singapore has enjoyed peace and prosperity and uniquely strong governance over the past several decades.
Singapore has a lot going for it. But for most of the past few years, the country’s real estate market has been trending downwards.
The following graph shows the long-term index of residential prices, from Singapore’s Urban Redevelopment Authority (URA).
As you can see, after decades of strong growth, prices for both residential real estate (the red line) and office real estate (the grey line) have been flat or trending downward in recent years. Residential real estate has seen a compound annual growth rate (CAGR) of 6.7 percent since the first quarter of 1975. And office real estate has seen a CAGR of 5.2 percent in that timeframe. This growth rate handsomely beats the long-term rate of inflation.
Why have prices been trending downwards in recent years? Well, there are two major factors at play here.
Firstly, Singapore has seen a persistent excess of supply of new residential units come into the market since 2013.
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New supply (the red bars in the chart below) in recent years has been way higher than it has been in the previous 15-plus years. Vacancy rates (the green line) have risen as this wave of new supply has come on stream. Those high vacancy rates have helped suppress prices.
Government policies have also hurt real estate prices.
As the price chart shows, in the lead up to the great financial crisis and in the years after it, prices rose dramatically. In an attempt to “cool” the market, a series of policies were implemented to slow the pace of price appreciation.
In 2009, interest-only mortgage loans were banned, along with schemes that let buyers defer repayments. The following year, a sellers’ stamp duty was levied on homes that were resold within a year of purchase in an attempt to reduce speculative activity. The maximum mortgage loan-to-value (that is, the ratio of a mortgage loan to the home’s value) was lowered.
Over the following three years, more measures were introduced, including additional stamp duties for foreign buyers (i.e., to cool Chinese speculative inflows) and further loan-to-value reductions on mortgage loans.
Excess supply and a set of government policies designed to tame the market did their job, and prices fell.
But that excess supply is now fading. As you can see in the graph above, new supply in the coming years will drop to levels closer to the long-term averages. And excess supply will likely diminish as vacancies fall in the coming year or two. This is the key catalyst for a country-wide increase in property prices in Singapore.
We’ve also seen a rise in en-bloc sales, which are redevelopment deals when a group of owners in a particular housing block do a unified sale to a developer (at a sharp premium to market price) – who then redevelops the real estate into a higher value site. This is a bullish indicator.
Last year, we also saw the government roll back some of the “cooling” measures it put in place to stem the rapid rise in property prices.
I don’t think we’re likely to see a further peel back of those measures in the immediate future, but any further rollbacks would be bullish.
As a result, residential prices in Singapore may be at or near the end of their downswing, and poised to move in the opposite direction in the coming year or so.
In short, the real estate industry in Singapore, in most sectors, has been trending very differently from real estate markets in most other parts of the developed world. This market has been on a downswing that appears to be ending.
These days, you rarely hear anyone mention European real estate securities. And they’re certainly not on the radar here in Asia.
Within the global listed real estate universe, the UK and Europe only make up 11 percent of the market capitalisation of the sector (according to MSCI Indices). They make up only 6 percent of the market capitalisation of the 50 largest real estate stocks globally.
Asia, by contrast, makes up 42 percent of the global real estate market capitalisation and accounts for 46 percent of the top 50 stocks in the sector.
But this overlooked sector offers a growing opportunity right now.
Let me explain…
After the global financial crisis (GFC), the U.S. took quicker and more evasive action to avoid a deep and long recession. For example, the U.S. very quickly established its program of quantitative easing (QE) in January 2009 and began a program of working out the mountains of non-performing loans and distressed real estate.
Europe did not move so quickly. In fact, it did not start its own program of buying QE until March 2015, more than six years after the U.S. Federal Reserve launched its own program. This earlier action in the U.S. led to a faster rebound in its economy and financial and real estate markets. Europe reacted slower… so its recovery is about two years behind that of the U.S.
But all the signs point to Europe’s recovery now being well underway and sustainable. After years of weak economic performance, third quarter growth for Europe came in at a solid annualised 2.5 percent and the fourth quarter is expected to be a repeat performance. This is a bit higher than the U.S., which is at 2.3 percent. It’s the first time since the crash in 2008 that Europe is growing faster than the U.S.
For 2018, growth in Europe is likely to be around 2.2 percent. And the European Central Bank (ECB) is still buying bonds under its multi-year quantitative easing program. That’s scheduled to be slowed down (though not stopped) in coming months. This continued money printing should continue to support liquidity and investment in the Eurozone.
Inflation is also likely to rise close to the ECB’s target of 2 percent in 2018. Unemployment is falling in most countries (Eurozone unemployment fell from a peak of 10.9 percent in 2013 to 7.6 percent by the third quarter of 2017) and aggregate investment is accelerating. (Aggregate investment has grown from minus 3.3 percent in 2012 to 3.7 percent in 2016 and is expected to grow further in 2017.) So the recovery is building momentum.
Still, as a result of its slower recovery, European stocks as a whole have massively underperformed the U.S. since the 2009 recovery kicked in. In U.S. dollar terms, the European market (as measured by MSCI) has recovered by approximately 88 percent since the 2009 trough. The U.S. market, by contrast, has moved up approximately 260 percent since the trough.
And European real estate stocks have underperformed U.S. real estate stocks significantly. U.S. real estate stocks have rebounded by close to 280 percent, while European real estate stocks have risen by approximately half that amount since the 2009 bottom.
But things are starting to turn around for Europe’s real estate market…
Right now, there are several themes impacting European real estate companies and real estate investment trusts (REITs).
First, the European real estate sector is seeing a generally low level of new construction (with the odd exception, such as residential real estate in central London), and low to modest vacancy rates – especially in the office markets in central business districts of major capitals or financial centres. Low vacancy rates mean landlords have increased ability to raise rentals as potential occupiers compete for limited available space. This in turn can increase earnings of property owning companies and the value of buildings, and the values of the companies holding them.
Meanwhile, the growth in online retailers is hurting retail properties in Europe, just as this sector has been hurt in the U.S. Some 50 percent of the growth in retail spending in Europe in the coming year or two is expected to be online. But this trend is a strong positive for the warehouse and logistics real estate companies.
Real estate consultant CBRE tells us that globally, industrial property prices are rising at close to 7 percent, faster than global office prices (4.5 percent) and retail prices (2.5 percent). It is likely that industrial property is benefitting from the slowdown in growth in traditional retail real estate as a growing share of retail spending is done online.
The global trend towards flexible work spaces is also impacting office markets. This concept allows individuals and companies to occupy shared office space in specially designed buildings. Typically, the occupier does not have to commit to taking out a dedicated long-term lease, so it reduces the risk for the business. Investment management company Jones Lang Lasalle’s (JLL) research suggests that in London, flexible work space operations are now accounting for about 16 percent of new office take up in terms of floorspace. That was around one percent in 2010. JLL reports that globally, growth of office rents is accelerating, and this is led by growth in western Europe. This growth includes both traditional rental models as well as flexible space models.
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Another big trend set to affect European real estate is Brexit. In simple terms, what is likely to be London’s loss will be many other cities’ gain. Many financial houses have already started plans to relocate staff and certain operations out of London to cities like Frankfurt, Dublin and Paris. Stock exchanges, clearing houses, lawyers, accountants and insurance companies will follow suit. And then we’ll see the manufacturers, exporters and trading companies also relocating parts of their operations.
I don’t for a moment believe that London will be hollowed out. But even small numbers of jobs moving from there to these cities can have a big effect on office and residential markets. These markets are quite tight in terms of supply anyway. So even modest amounts of new demand appearing in an already tight market is likely to increase rentals and prices.
Then there are interest rates…
When we think about prospects for real estate markets and stocks, we often circle back to interest rates. You see, rising interest rates raise the costs of debt in real estate companies, and can hurt profits. But in today’s extremely low interest rate environment, the impact of rising rates on the bottom the line of most real estate companies is minimal.
More important is the impact that rising interest rates have on property yields and capitalisation rates used to value properties. There is sometimes a relationship between the yields that investors are prepared to accept for property investments and the cost of capital.
In short, when interest rates rise, investors may require a higher rental yield on their property investments. For a given rental income then, they would expect to pay less for that property.
The yield/price relationship for real estate can be similar to that of bonds. When interest rates go up, the price of bonds comes down. (The key difference in real estate, of course, is that rentals can change over time, whereas as for bonds the coupon is typically fixed.)
This is the situation we see in much of Europe right now. Rental prices are rising, so investors can expect to receive higher rental yields on their properties. And that expectation of rising income might encourage higher prices for real estate acquisitions.
The spread between bond yields and rental yields on property can be an indicator of how cheap or expensive real estate markets are. For most forms of prime office, warehouse and certain residential markets in Europe, the spread between property yields and government bonds can be as high as 5 to 6 percent.
For the overall real estate market in the U.S., the spread of property yields over 10-year government bond yields is around 200 basis points (2 percent), according to investment bank UBS. That is around the long-term average. For Europe, that spread is 400 basis points (4 percent).This spread is 100 basis points higher than the long-term average.
This tells us that European real estate is cheap relative to the U.S. market on this metric, and cheap relative to its long-term history.
And the European interest rate environment looks fairly benign at this point in the cycle. The U.S. Federal Reserve has embarked on a path of raising short term interest rates. But even the most extreme forecasts suggest that short-term rates will not rise by more than 100 basis points over the coming year.
In Europe, the spread between 10-year German government bonds and the two-year bonds are still a little wider than the long-term average. If that spread approaches zero, or goes into negative territory, it tells us that markets are expecting a recession, or at least a significant economic slowdown. That is far from the case at this point.
In addition, there is very little expectation of the ECB raising rates anytime in the next six to 12 months. The ECB has not yet stopped QE.
The ECB is way behind the Fed in the QE stakes. The Fed confirmed ceasing of its bond buying program in October 2014. Meanwhile, in December 2016, the ECB announced plans to cut the monthly amount of bond purchases from €80 billion to €60 billion in the first half of 2017. And this October, it announced there would be further cuts in January to €30 billion per month.
But just as the end of QE in the U.S. has had little negative impact on financial markets, I fully expect a similar outcome in Europe when the ECB finally stops its QE.
So overall, European real estate markets are in a good space right now. They’ve substantially underperformed U.S. real estate stocks – and even Japan and Asia-Pacific real estate stocks. They’re also trading at much lower earnings multiples than their U.S. peers. And on top of that, the dividend yield for the sector (at around 4 percent) is higher than it is for other major markets (like the 3.3 percent yield in the U.S.) So European real estate stocks are a good place to see decent lower risk returns in the coming year or so.
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I recently showed you three ways emotions can cost you big in real estate investing.
To start off the new year… today, I’m revealing three more emotional responses to watch out for – and how to overcome them – when you invest in real estate…
Everyone likes being proven correct. Most people look for information and insight to confirm what they already believe – and avoid information that challenges their pre-existing beliefs. Often, even less-than-clear evidence is used to support what people believe.
This is called confirmation bias (or “my-side bias,” or “verification bias”). It shows up in many ways, including how we research real estate investment opportunities.
For example, a real estate investor who enjoys the benefits of a housing boom is likely to attribute his or her success to personal acumen and skill. In contrast, investors who see the value of their real estate holdings plummet tend to blame the market, other investors, or just plain bad luck. Our brains look for ways to confirm our beliefs.
Confirmation bias is easily seen in politics. Those on one side of the political spectrum tend to look only at news and information that supports their pre-existing beliefs. Those on another side only consider news and insight that support their political positions. Both groups typically ignore evidence supporting the other side.
So how can you overcome it?
The first step is to recognise that your brain is programming you to confirm your own beliefs. Once you realise this, it’s a question of actively seeking out information that goes against what you believe and understand. Find a view that’s contrary to your own and think about it for a while.
You may – actually, you probably will – wind up believing the same thing. But your investment decisions may benefit from a conscious effort to deal with this bias.
When it comes to investing in real estate (or any other asset, for that matter), your parents may have given you the best advice: “If everyone else decided to jump off a cliff, would you do the same?”
People tend to follow the herd. We think if everyone else is doing something, then it must be the right thing to do. But, there is often no good, rational reason for doing what everyone else is doing.
This bandwagon effect is what happens when you do what others do without making a reasoned, objective decision on your own.
Herd behaviour also drives real estate bubbles around the world. From Thailand and Hong Kong to New York and London, buyers piling into the market have caused real estate prices to skyrocket.
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The bandwagon effect clouds our judgment about specific investments and prevents us from thinking clearly when analysing an investment. If you follow the herd into inflated real estate markets without forming your own informed opinion, you’re likely in for a rude surprise when the bubble bursts.
Some of the best investment decisions are those that go against the grain. This is called contrarian investing – you buy when the crowd is bearish and you sell when everyone else is bullish.
Buying when most people panic and selling when the bandwagon crowd is certain prices will increase is very difficult, but it can be remarkably rewarding over the long term.
Avoid being part of the herd. If everyone you know is talking real estate and newspapers are publishing overly optimistic news, it may be time to consider the contrarian view and be conservative.
As your parents said, just because everyone else is doing it does not mean it’s the smart thing to do.
In the real estate world, as in every field, there are experts who can give you good advice and guidance. But relying too much on “experts” can sometimes be just as bad as investing blindly. That’s because no one, not even experts, is right all of the time, or even most of the time.
Over-reliance on experts is often called the seersucker illusion, from the expression “For every seer, there is a sucker.” In the realm of real estate, realtors and appraisers are some of the professionals you have the most interaction with.
Remember though, that appraisers can also fall victim to cognitive bias. And then there’s the issue of conflicting interests.
For example, your realtor may try and convince you to accept a low bid price because they benefit more from a quick transaction than a long negotiation.
It’s important to think for yourself and not put too much faith in experts, especially in an unpredictable field like real estate.
So don’t be a sucker. You may get excellent advice from people you trust and respect, but make sure you form your own opinions as well. If you are looking for expert advice, try consulting more than one expert, especially ones with different viewpoints.
Publisher, Stansberry Churchouse Research
(A very happy new year to our readers… and a profitable 2018!)
Right now, you could be making several dangerous investing mistakes… and you likely don’t even realise it.
You see, stress causes our brains to react with powerful emotions. These unconscious, instinctive reactions can lead to big mistakes – even for the savviest of investors.
And investing in real estate is probably one of the most stressful, and emotional, transactions you’ll make in your life.
What follows are three of the most dangerous real estate investment mistakes that can result in poor decisions… and how to be sure that you don’t make them.
Have you ever had a large bank note, but didn’t want to use it to buy anything? Yet, you had no problem using a bunch of smaller notes to pay for something?
This is known as the denomination effect. Studies have shown that people hesitate to break a $50 note, but don’t mind spending three $10 notes and four $5 notes. When the value of a bank note is smaller, it makes us feel like we are spending less.
The denomination effect can also poison the brain of real estate investors.
For example, let’s imagine that a real estate investor, perhaps one who invests in rental properties, sees a home in an attractive neighbourhood that is priced well under the average price per square meter in that area.
He figures, sure, it’s probably cheap because it needs some work, but at this price it’s impossible to turn down.
The deal is done and suddenly our investor finds he has a money pit on his hands. By the time he’s finally made enough improvements to find a tenant, months have passed and he’s spent even more than he might have buying a more “expensive” property.
That is how the denomination effect works. Prices that are low can cause behaviour that results in spending as much – or even more – as would have been spent buying a property or stock with a higher price tag.
One way to deal with the denomination effect in real estate is to get a realistic valuation – and how much the required fixing up will cost. You also need to consider the time involved in making the property livable. These factors are relevant whether looking at the property as an investment or a home. Remember, what looks cheap at first sight may not turn out to be.
Let’s say one month property values go up 5 percent. But the month after, they fall 5 percent. Of course, making money, even just paper gains, is better than losing money. But, is the joy of winning greater than the pain of losing?
Research has shown that for most people, it is not – losing feels worse and our minds experience actual pain when we lose money. The pain we feel from losing is greater than the pleasure we feel from winning an equal amount.
Hating losing more than loving winning causes investors to over-exaggerate risk and play it safe. So, even if the chances of making money are better than losing money, most investors will avoid the opportunity altogether.
Loss aversion can have a negative impact on real estate investors, particularly those who bought property at elevated prices during a bubble. Loss aversion often makes real estate investors reluctant to sell when prices fall, even when it’s unlikely that prices will bounce back anytime soon.
By hanging onto a property that has lost money, investors may miss out on the opportunity to invest that money in something more profitable.
So how can you overcome loss aversion?
The Overnight Test is a simple way to avoid making a bad decision because of loss aversion.
Say you invested in a property that declined in value and are now faced with the decision of whether to sell at a loss, or keep holding it. It’s painful admitting you were wrong, of course. But imagine you went to sleep and overnight the asset was replaced with cash. In the morning, would you now use that cash to buy the property at the current market price – or invest it somewhere else? If you wouldn’t buy the property even at this lower price, you should probably sell.
Hong Kong multi-millionaire reveals his simple strategy for making 200x, 9x and even 1,280x returns in an investment you’d never expect.
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Every investment, whether it’s stocks, bonds, real estate or commodities, fluctuates in value. Prices rise and they fall, and then they do it all again… and again.
Despite this predictability, most investors are caught off guard by these market cycles. Real estate price rise, oftentimes very quickly, and then the bubble bursts, leaving everyone surprised. It’s such a surprise because of status quo bias.
That means we tend to think things are likely to remain the same – because our most recent memory is of them being a certain way. Investors buy real estate in hot markets because they expect it to continue going up. Investors expect this because, well, the market has recently been rising. Status quo (Latin for “the state in which”) bias helps them forget about cycles.
Investors fall victim to status quo bias because they believe the four most dangerous words in investing: “This time it’s different.”
Of course, nothing is different. The cycle always prevails, the bubble bursts and prices fall.
Hong Kong’s supercharged real estate market offers one example. Between 2009 and September 2015, residential real estate prices more than doubled. But then in November 2015, sales and prices started tumbling. As of the end of February 2016, prices had fallen an average of 10 percent, and sales fell 70 percent compared to February 2015.
So this time was not different. Hong Kong’s currency is pegged to the dollar, and fears that the U.S. Fed would raise interest rates before the end of 2015 triggered fears that Hong Kong mortgage rates would also rise. The demand for housing fell and prices along with it – just like every other cycle that’s come before.
The best way to beat status quo bias is to procrastinate.
Behavioural economics studies have shown that if asked to make a particular decision about something by the end of the day, people are more likely to decide to leave things unchanged. Change is hard and the status quo is easy. And, when you don’t give yourself time to make a decision, it’s easier to keep things the same.
But, when people are asked to make a decision by the end of the week, they’re more likely to think carefully – and decide based on facts rather than the comfort of the status quo. That suggests change comes more easily if you have time to get used to it.
So the next time you think that this time is different, wait a bit. You may realise that, in fact, it isn’t different and almost never is. That can be difficult to accept when real estate markets are hot, but it’s a relief when the bubble bursts.
To sum up, we all have emotional responses we don’t full recognise when it comes to investing our money. Even the savviest investors sometimes give in to their emotions. So before you make another real estate investment, stop and make sure your emotions aren’t costing you money.
Good investing in the new year,
Publisher, Stansberry Churchouse Research
If you want to profit from real estate stocks, there’s one important thing you need to know…
Not all listed real estate stocks are the same.
If you want to build out a diversified real estate stock portfolio, it’s crucial that you understand this. You see, some real estate stocks offer growth… meanwhile others offer value… and others offer income.
And different real estate stocks present very different risk/reward profiles. For example, at one end of the spectrum we have stable, low volatility income-generating investments… and at the other end, we have speculative growth plays. And then there’s everything in between.
As investors, this gives us the flexibility to structure our real estate portfolio in a way that suits our preferred risk/return profile. And it allows us also to diversify across different property types within different property sectors.
To explain… there are four different types of real estate stocks.
These property companies are like manufacturers. They buy raw material (land), they manufacture (build) and then they sell the completed product. One big difference is that the development process involves a much greater time frame than the typical manufacturing process.
This is a buy-and-sell model. It’s all about buying land, building, selling, buying land, building, selling… the faster and more efficiently a company can do this, the more profitable it can be.
Pure developers all have certain characteristics… Their businesses are highly cyclical, as are their earnings. So investors should be ready to stomach volatility. This business model has highest asset turnover of all property models.
And in many markets, these stocks have a high beta. That means that they tend to go up and down at a greater rate than for the overall market.
Property developers are by far the largest group by market capitalisation in Asia, but a relatively much smaller group in other developed markets like North America, Europe and Australia/New Zealand.
This group typically buys or builds properties that are intended to be held for longer term rental income and capital growth.
Rentals and capital values can be cyclical, but earnings are typically less volatile than for developers. Earnings, being driven largely by rentals, are generally more reliable and more predictable.
These companies generally have low asset turnover (they hold on to assets for long periods), and therefore a typically lower return on equity/return on capital.
In Asia, these tend to be the second biggest group in the sector, but are a smaller part of the sector in the U.S.
These are a particular type of real estate company that follow very specific rules dictating what the companies can do and how they behave.
The vehicles hold investment properties for the long term and are required by law to pay out approximately 90 percent of their net income as dividends to their shareholders. They are not normally required to pay out profits derived from asset sales to shareholders or gains from property revaluations.
In most jurisdictions, there’s a set amount of development that these companies can undertake. And in some places, maximum gearing (borrowing) levels may also be preset – along with the jurisdiction of properties allowed to be held in a vehicle.
Such vehicles are designed to provide a low risk, high dividend real estate based asset class for investors.
Earnings and dividends tend to be fairly predictable and have low volatility. Earnings growth tends to be low (it is based on rental growth to a very large extent), along with the return on equity.
REITs tend to have a lower beta, in that shares will tend to go up less than the overall market but go down less than the overall market in a falling market.
In the U.S. and Australia, REITs are by far the largest single sector of the listed real estate space. They are a much smaller proportion in Asian markets. In the U.S. and Australia, REITs have been around a long time, but are a much newer development in Europe and Asia.
This group includes real estate agencies, property management companies, real estate finance companies, construction companies and buildings materials suppliers.
Many banks have a high proportion of their total loan books allocated to real estate of one kind or other – including real estate services such as materials and equipment suppliers. In Asia, many banks have had more than 50 percent of their loan books exposed to real estate in one way or other at various times.
In markets such as the U.S., there is a body of specialist real estate finance companies that operate in different parts of the real estate market.
Depending on what’s going on in the market, there may be good reasons to focus on one type of real estate stock over another.
For example, in an environment of low interest rates, investors are usually desperately searching for low-risk yields. That demand has led investors to the REIT space in some markets. Dividend yields tend to be substantially higher than interest on bank deposits or bonds.
Or consider this… housing development slowed dramatically in many countries in the immediate aftermath of the 2008 global financial crisis. As demand for housing came back on line with the economic recovery, it was met with a shortage of new supply. So developers were needed to fill the gap… increasing their prospects.
Rapid growth in populations or exports can also increase the demand for new housing, buildings or manufacturing centers… another positive tailwind for developers.
So before you invest in real estate stocks, consider the risks, rewards and the type of market we’re in.
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