Bubbles, crashes and financial crises have been recurring phenomena in financial markets from their inception up to and including the current moment. However, the ferociousness and velocity of potential contagion has never been higher.
The term “bubble” may refer to periods in which the price of an asset exceeds fundamentals because investors believe that they can sell the asset at an even higher price to some other investors in the future.
The influential economist John Maynard Keynes distinguishes investors, who buy an asset for its dividend stream (fundamental value), from speculators, who buy an asset for its resale value.
Bubbles, crashes and financial crises have been recurring phenomena in financial markets from their inception up to and including the current moment. However, the ferociousness and velocity of potential contagion has never been higher.
The term “bubble” may refer to periods in which the price of an asset exceeds fundamentals because investors believe that they can sell the asset at an even higher price to some other investors in the future.
The influential economist John Maynard Keynes distinguishes investors, who buy an asset for its dividend stream (fundamental value), from speculators, who buy an asset for its resale value.
The structure of financial crises has two phases: the run-up phase, in which bubbles and imbalances form, and the crisis phase, during which risk that has built up in the background materialises.
The problem is that the “run-up” and “crisis” phases cannot be seen in isolation —they are two sides of the same coin. Herein lies the biggest challenge for real estate investors – illiquidity.
During the run-up phase, asset price -bubbles and imbalances form. Usually, these imbalances build up slowly in the background and volatility is low. Initially, the imbalances that lead to a financial crisis are often hard to detect. However, as the bubble gains momentum, it becomes clear that the fundamental improvements that may have warranted an initial increase in asset prices cannot keep up with ever-increasing valuations. A bubble has formed.
What amplifies the risks of the bubble dramatically are improvements in valuation that are not as a result of improved or -perceived improvement in fundamentals, but purely easier access to credit. The reason is that the bursting of credit bubbles leads to more deleveraging and stronger amplification mechanisms.
To illustrate this, think of the bursting of the technology bubble at the turn of the century. While this caused significant wealth destruction, its impact on the real economy was relatively small. Compare this with the bursting of the recent housing bubble, whose distinguishing feature was the preceding credit boom. Similarly, the run-up in stock prices during the 1920s was, to a large extent, based on credit in the form of margin trading; that is, it was financed through short-term loans. This credit-fed boom led to the Great Depression. The Scandinavian crisis in the early 1990s and the Japanese “lost decade” were also preceded by lending booms that led to excessive asset prices.
As a result of the globalisation of the financial markets, CRE is no longer an “alternative” or “tactical” asset class, but a crucial component of any diversified investment portfolio. Needless to say, the more that real estate is used to diversify investment portfolios, the less it is capable of providing a correlation hedge. Arguably, this is the efficient market arbitrage of globalised markets. Any measure of non-correlation is more to do with a lack of data than actual correlation.
Ultimately, the equity in leveraged real estate investments becomes a mere option. The investor has the option to refinance, -collect income and benefit from any capital growth. That is assuming the ability to -refinance is available, the income stream remains and capital growth is achieved.
There is no doubt that UK CRE is in the midst of a bubble. Valuations and the erosion of the risk premium, by and large, do not justify the property return. This is in contrast to the US, where real estate risk -premiums of 3-4% over the price of corporate debt are being achieved.
Moreover, volatility is starting to rise. As investors prepare for rate hikes, volatility is beginning to normalise. To be sure, volatility is still low by historical standards. However, an impending rate hike and slightly less benign credit conditions are having the -predictable impact of nudging volatility higher. As a result, valuations are likely to matter more as markets become less driven by momentum.
The chances of the “run-up” phase being cut short due to collapses in other financial markets or geopolitical events destabilising the financial markets is higher than the chances of UK CRE bursting its own bubble. It is as a direct result of the globalisation of financial markets that real estate investors need to be more concerned about the quantity and quality of debt within their real estate portfolios, as well as the potential impact of competing leveraged portfolios.
Michel Heller is a fund manager at Gowers Fund Management
