When it comes to valuations across asset classes, many investors are experiencing a sense of déjà vu. Asset prices have risen substantially, back to the levels we saw in the middle of the 2000s in some areas, against a backdrop of accommodative monetary policy. At the same time, yields are at historical lows and risk-taking has become widespread across markets. As we look back on a decade since the peak of the previous market cycle – and the global financial crisis – it is clear to us that the investment landscape is exhibiting some distinctive characteristics. This article examines some examples of current market conditions, which we believe support the case for allocation to real assets. We argue that investment in private markets-related strategies (including private debt and direct real estate) can potentially add an important stream of income and return potential to a portfolio, which is largely uncorrelated historically to traditional asset classes. But as the current cycle looks set to potentially reach its peak at some point over the coming months or years, and market behaviour is harder to predict than ever, we believe that the most successful investment approaches may be those which go ‘back to basics’. To us, this means focusing on direct origination of opportunities or in some cases ‘creating’ our own assets and seeking to create value by deep operational involvement. Conversely, this means that potential returns are not driven by adding leverage, beta exposure, complex structuring or seeking longer duration.
Buyers for everything – demand and prices have risen across asset classes, but yields remain low
It’s no secret by now that valuations are at historically higher levels across markets. Traditional asset classes like equities and bonds have seen sustained positive performance, and so have prices in real assets. As an example in the context of commercial property, an office building in the City of London affectionately known as the ‘Walkie Talkie’ was sold to a Hong Kong based herbal health products company this year for 1.28bn GBP, creating a new record high price for any office building in London. But putting the yield and price aside, the most striking thing about this is that the Walkie Talkie was built only recently – completed merely three years ago in the summer of 2014 at a total build cost of 473m GBP – so it was sold for nearly treble the cost of construction, something that was ‘virtually unprecedented’ in the words of the seller of the asset1.
But it’s not just London’s traditional ‘safe haven’ property market that is seeing extreme demand. In June this year, the Argentinian government sold a USD3bn bond with a maturity in 100 years, where the offering received nearly 10bn USD of orders and was thus 3.5 times oversubscribed. Remember that since 2002, all the way until last year, Argentina was consistently either in default or restructuring its debt – perhaps unsurprising for a country which has defaulted eight times since its independence. At this point in the cycle, it seems to us like there really is a buyer for just about everything. In parallel, yields are at historic lows, where the European high yield bond market (which includes junk-rated companies from ‘BB+’ all the way to ‘C’) is yielding 2.4%2 – ‘high yield’ feels like a total misnomer.
Figure 1. Yield on European HY bonds
Source: BofA Merrill Lynch Euro High Yield Index Effective Yield, 4 August 2017.
In this context, increasing numbers of investors are looking to real assets to help diversify their portfolios and provide potentially complementary income streams. One area here is residential real estate, but even here there are significant divergences in the value offered between geographical areas. Compare house prices in Sweden to those in the US, for example. In Sweden, house prices have had a nearly 25-year bull market since the early 1990s. As a result, in Sollentuna, a normal northern Stockholm suburb, a typical middle class family could spend 9m SEK (over 900k EUR or 1m USD) on a 30-year old, 200 square metre single family home3. In the US market, on the other hand, which experienced the deepest housing crisis in history between 2006 and 2012, in many sub markets house values are only now back to pre-crisis levels – so that same 200 square metre single family home, but brand new, might sell for 200k USD (170k EUR) in cities like Atlanta or Charlotte4. But strikingly, the average household income between these American cities and Stockholm are in the same ball park5 – highlighting a substantial affordability gap, where a comparable US single family home could cost a fifth of that in the Stockholm metropolitan area.
How can investors capture opportunities in this context?
This current landscape presents a number of challenges for investors – perhaps most significantly, many are being pushed up the risk spectrum in search of yield and return. There is no ‘magic’ solution to this dilemma, but in an environment like this one, we believe it may be wise for investment strategies to be positioned conservatively and proceeded with caution. In recent years, where markets have continued to generally perform positively (valuations have risen), we have adopted a conservative position, and believe that it is important to seek assets which provide a margin of safety. In practice, this means that on the private credit side, we favour a focus on senior secured loans, backed by quality real estate assets and with lower ‘loan to value’. In this way, we believe that investment can potentially generate a stable but modest set of returns within a low-risk framework over time – rather than chasing returns further up the risk spectrum. In addition, we prefer shorter duration private debt investments, which offer the potential to rebalance or reinvest capital in new opportunities as appropriate as the cycle turns.
When it comes to investing in direct real estate, in recent years we have focused on US residential markets, which we believe remain more affordable to homeowners in contrast to many other developed markets. Again, we feel this approach goes back to basics, taking a defensive approach using detailed due diligence and operational efficiency, rather than financial leverage as primary source of potential return. Indeed, we see a range of potential opportunities in this space which we believe may offer an attractive mix of risk and return over the medium term. Examples of these would be in cities such as Atlanta, Dallas, or Charlotte– where there have been opportunities to acquire and build individual single family homes. Many of these properties are situated in middle class neighbourhoods with well-regarded schools nearby. From an investment perspective, they present opportunities for renting, especially where tenant incomes are relatively strong. Given that mortgage availability remains constrained following the sub-prime crisis ten years ago, while many people are still repairing their credit scores (it tends to take around 7-9 years following a default to re-qualify as ‘prime’6), these families have the option of renting a home before buying back into the market.
Conclusion – avoiding the race up the risk spectrum
Undoubtedly, the decision about how to invest today will be driven for many investors by their view of when the cycle will turn. With valuations high across a range of asset classes, increasing numbers of investors are starting to become more cautious. In this environment, we believe patience is a virtue and the most successful investment strategies may be those which can hold their conservative positions while the cycle matures. When the market turns, we may see a larger and more diverse opportunity set – across geographies, markets and asset classes – but until then, it’s back to basics.
1. Rob Noel, CEO of Land Securities, as quoted in the Daily Telegraph, 27 July 2017.
2. BofA Merrill Lynch Euro High Yield Index Effective Yield, as at 3 August 2017.
3. Source: Hemnet, 2017.
4. Source: Zillow, 2017.
5. Source: Salary Explorer, accessed August 2017, showing average monthly salaries. Stockholm: 39,192 SEK, Atlanta: 7,059 USD, Charlotte: 6,746 USD.
6. Source: MyFICO, 2017.