By Alessandro Pasetti, 15 February.
There are books you read that never leave you, and following the huge swings in financial markets since early February, I was reminded of some of those when thinking about how real estate investors ought to consider their positions in relation of other forms of investment.
Is a financial meltdown around the corner?
Watching financial market events unfold by the hour is bad for your blood pressure, but some lessons I learned from reading have often helped me make better choices.
I have closely monitored the ups and downs of the past 20 years, from the dot.com bubble at turn of the century to the real estate and banking crash a decade ago and, indeed, further back. When I was a kid the private equity binge of the 1980s culminated in 1987’s Black Monday, which remains a worst-case scenario in terms of making investment decisions. In those years junk bonds doped financial markets where stellar inflation rates were still dropping from the second Oil Shock in 1979.
I have been thinking about how these events (most I read in the books mentioned below) shaped my behaviour in finance matters, and how correlated they were to prevailing interest rates trends of the times.
Ultimately, I want to help you filter all the nonsense written when the bears, with grand fanfare, point to the nearing collapse of the real estate market, driven by a financial meltdown — there have been many strange headlines in the British press in both regards lately, spurred by the recent fall in the FTSE 100.
One typical Inveztments reader recently argued that comparing, for example, the housing markets in Milan to London, and their historical trends, it was easy to predict a further 50% decline in prices in London over the medium term. The lesson this gentleman appeared to forget was to compare apples with apples; barring growth considerations, here we have two very different investment by liquidity (and location).
Which reminded me of When Genius Failed.
That book changed my perception of risk: a masterstroke of how the cleverest humans on earth made their fund implode because their binary trades, which were meant to be perfectly hedged, weren’t hedged at all. Masterminded by Irish-American fund manager John Meriwether and other brilliant fellas, Long-Term Capital Management (LTCM) used the work of finance scientists Scholes and Merton, who were awarded the 1997 Nobel Prize in Economics thanks to their option pricing modelling.
“Scholes’ work had inspired a generation of mathematical wizards on Wall Street, and by this stage both he and Merton were players in the world of finance, as partners of a hedge fund called Long-Term Capital Management,” the BBC wrote years ago.
Look at the demise of LTCM, and how it financed its trades — think of it as if you bought a property, remortgaged your equity shortly thereafter, and then with that borrowed money bought a risky investment where Bitcoin is the riskiest in the spectrum today. That, in 1998, was Russian debt, which plummeted in value during a very hot summer for many traders.
Leverage clearly compounded problems of a fund that evaporated in a flash, just like this month the value of a security conceived by Credit Suisse – essentially set to trade against volatility — evaporated overnight.
In late September 1998, LTCM was taken over by its lenders — in those days interest rates in the US rose 200 basis points to 4%, then reaching 6%. By comparison, in recent weeks US benchmark rates have risen swiftly from only 2% to 2.8%.
(Your cost of funding might soon go up more than that, depending on how banks react, increasing your mortgage costs.)
They say real estate is risky…
In the 1990s it began with LTCM and ended with Enron, which declared bankruptcy in December 2001. Rates during the LTCM-Enron period — at the post-heights of the dot.com bubble — rose from 4.4% to 6.6%, more than doubling current levels. Enron shareholders, of course, were wiped out.
The classic tale of the Enron affair is The smartest guys in the room. It touched upon capitalism and side effects, I learned that accounts can easily be faked even though regulators should prevent retail investors — you and I — from being scammed. Enron (click here to see how its downfall began) was essentially a massive conglomerate of Chinese boxes where accounting fraud was the rule. The property market is a good example of transactions that are often opaque, and that is why due diligence is an affair you often need help for. The Team of Inveztments performs close scrutiny on builders, and their financials, and this is clearly a plus.
Before we move onto the third book and why all of this matters to real estate investors, think about where the 10 US Treasury bonds trade – what’s their yield?
While it is true that regionalisation in the real economy poses a threat to globalisation, finance is global and all markets are intimately tied to the driver of value — the US, where the fall in stock and bond prices in the past few weeks shocked, and badly harmed, stock and bonds traded in Asia and Europe.
Shorting Europe and the euro? A bad idea?
Call it transmission effect: interest rates in the US matter, and no doubt the Bank of England is looking to catch up with the Fed and open the gap with Europe in terms of interest rates hikes. The Fed was the first brave bank to push up rates a couple of years ago, although interestingly, it has been slow since.
Finally, The Big Short is a thoroughly entertaining read, even if it does describe the near-complete demise of the entire financial system, and the world as we know it. When Lehman Brothers collapsed due to troubled bets on derivatives and real estate, interest rates fell from 3.8% to a floor of 2.2%, but the plunge had started earlier when rates were at 5%.
The allure of barring a Japan-like scenario is obvious, but there are similarities. (Seeking Alpha this week wrote: “Japan’s economy grew at an annualised rate of 0.5% in the final three months of 2017, capping an eighth straight quarterly expansion and the longest growth streak in nearly 30 years”). This could be a very long cycle, which gives more time to profit to investors and realtors.
So, if you are ready to bet on short-term capital appreciation in the housing market, make sure you gauge what kind of risk you are embracing before the US reaches the critical 4.5%-6% threshold at some later point — given the shape of the yield curve, and three likely rates hikes each of 25 basis points (0.25%) a year in 2018, 2019 and 2020, you’ll have time to reap the rewards before the next financial meltdown occurs. And by then you’ll also hold an investment with more defensive characteristics.
To contact the team of Inveztments and discuss the prospects of their flagship projects please click here.
(This post was written by Alessandro Pasetti. Ale is the founder of Hedging Beta Ltd. He writes about investment strategy and assets valuation for European clients as well as Seeking Alpha. Based in London, he previously worked for about five years at Dow Jones/The Wall Street Journal, producing analysis for the IB community. Prior to that, he contributed to the launch of London-based Loan Radar, where he worked for three years. He had stints in equity research at Bear Stearns in London, HVB in Munich, and Unicredit in Milan.
It was edited by Gavin van Marle, managing editor of London-based The Loadstar. Gavin is also the author of the book Around the World in Freighty Ways: Adventures in Globalisation. He has won numerous awards, including the Seahorse Journalist of the Year 2011 and 2009, and Supply Chain Journalist of the Year 2010 and 2014. )