Driving With The Rearview Mirror: CRE Needs A New Roadmap For Recession Risks
Navigating the post-pandemic economy is turning out to be hard. Ahead are hidden hazards, sharp corners and unpredictable oncoming traffic.
UK inflation rose to 9.1% in May, according to data released today. In the U.S. it is 8.5%, both at 40 year highs and both expected to grow. Energy prices are soaring, and growth on both sides of the Atlantic is doubtful: U.S. first-quarter growth was 0.1% whilst UK GDP fell by 0.3% in April.
Nobody expects a sudden recovery anytime soon. Central banks have a choice of raising interest rates and stymying growth further, or letting inflation rip.
All of which poses a problem for commercial real estate seeking data to drive decision making. It boils down to: Which direction is property looking for its journey into and out of recession, forward or back?
Rearview Or Forward-Looking?
Talk to big money — or even midsized money — and investors are already living in 2024. They are poring over myriad economic data sets and forward-looking indicators, trying hard to spot trends before they are trends. They are living life, literally, ahead of the curve.
Then talk to agents and many developers. They tell you about five-year averages, historic take-up, the micro-history of leasing in this location or that. Their data sets are narrowly focused on real estate and point firmly backward — last quarter, last year, even last decade. They are driving with the rearview mirror and when it comes to the future, there’s no numbers, only hunches.
When a looming recession means the future begins to feel very different from the past, the reliance on traditional market data can cause problems.
The property industry has long relied on backward looking data. “Traditional metrics such as historical market activity and economics have always been relevant for real estate decision makers," BNP Paribas Real Estate Head of Research and Insights Vanessa Hale said.
"Even to this day, where the previous impact on markets or capital flows can be examined to draw parallels when assessing current investment opportunities or risk factors."
Agents have historically been relied upon to provide historic market data, which made sense as they tended to have the market coverage of transactions and deals readily available and, of course, the ‘on the ground’ knowledge and insights to back it up, Hale said.
“This is what always happens in a market turning point, with some thinking in terms of yesterday's pricing and liquidity, and others looking forward," M&G Real Estate Head of Investment Strategy Jose Pellicer said. "And the first effect is on liquidity because the prices sellers are prepared to accept are not the same as those the buyers are offering.”
The early warning signs of a mismatch between forward-looking and backward-looking data comes in the form of bid numbers, Pellicer said. “It’s only anecdotal, but the noise we’re hearing on how many underbidders there are gives you an idea of where the market is going,” he said.
Pellicer said this happened in 2010 and again in the 2013 euro crisis, and is part of what some observers call the “normal malfunctioning” of the property market. And it is not all bad news. Gaps between what buyers and sellers expect are much-prized spaces in which hopes can flourish and shrewd bets pay off.
It's Behind You
Tom Wallace is the founder and chief executive of Re-Leased, whose commercial property management software yields interesting data on who pays rent, how often and how much. During pandemic lockdowns Re-Leased data helped landlords and policymakers assess the state of the market.
Wallace said agents and developers with strong local knowledge have a feel for a market, “which means they can make a good guess about the future”. But institutional landlords, without this local touch, turn to wider data trawls in the search for comforting information about what’s coming next. “And this creates a tension because they come up with different answers — and that in turn creates opportunities, because they can’t both be right,” Wallace said.
Wallace even goes so far as to suggest too much reliance on forward-looking data could be dangerous.
“Taking bold moves on forward-looking data comes with a risk, because the story isn’t written yet," he said. "Think back six months when we all thought the market was coming nicely. And now today that feels very different. Too much is in flux to rely too much on forward-looking data.”
Don't Look Back In Anger
Yet driving real estate strategy on the strength of historic data has some serious downsides, downsides now exercising the minds of property number-crunchers.
“More holistic intelligence is required to support current day investment decisions, and examining socioeconomic trends has become a staple in the investor and developer decision making process,” BNP Parisbas’ Hale said, tipping her head to the firm’s Next X data tool and its alternative metrics.
Re-Leased’s Wallace is also working on new data tools to meet this need. “Our data shows what is happening right now, but as it stands today it doesn’t tell you much about the future, but that’s something we want to bring in, using other data sources. You need a picture of the future just as you need to know where you are today,” he said.
The trouble is that new forward-looking data sets are not coming quickly enough to meet a rapidly changing economic situation. In the meantime old habits are taking control — and the oldest and most dangerous is to assume that property is all about capital values.
Matthew Richardson is the founder and chief executive of Income Analytics, the MSCI and Savills-backed data firm that provides investors with global rental default risk measures at tenant, asset, fund and portfolio levels.
“Elements of the property industry are a little bit stuck on data looking backwards, and at the kind of inflexion point in the economy we are at now, that can feed into an over-reliance on valuations, which of course are carried out with backward-looking data,” Richardson said. “Valuations are often on the back of comparables from six or 12 months ago, which are now seriously out of date."
Richardson said the property market needs to learn to analyse assets in the same way that debt and equity markets look at value, “modelling the future based on assumptions about the next five years, not what happened in the last five years”.
In particular, this means treating rent (and hence yield) as the main focus, and not capital values. Richardson argued a lease is a kind of borrowing arrangement — the tenant gets space (the principal) in return for rent (interest) and the landlord gets the principal back at the end. And if you think of property income as a kind of debt, everything becomes clearer. “What matters is you focus on default and the risks of default in the future — how likely a tenant is to go bust — and in a recession we know some business flourish and others don’t,” he said.
“What killed the market in 2007/08 was that everyone looked at capital values and no one looked at the cash flow underlying those values — the capacity to pay rent — and that evaporated, and so nothing was worth what they thought it was.”
Keep your head straight and eyes fixed on the road ahead, because what’s coming toward you matters most, Richardson said.
In Richardson's view, the juggernaut heading property’s way is the end of quantitative easing, as signalled by the end of the super-low interest rates that came hand-in-hand with it. “We’ve created a zombie economy with a load of businesses paying rent who wouldn’t normally survive,” Richardson said. When those businesses collapse there will be a high property price to pay — and no amount of historical take-up data or rental curves will help you spot that moment.
What commercial real estate needs is a big think about the data it values. “Property has become a global asset class but the analytics hasn’t caught up,” Richardson said.
Driving Conditions: Poor
To look ahead into the future, or back at the past? Front-facing or perpetually rearview glancing?
So long as parts of the market are looking in different directions there will be tensions, tensions most apparent in the pricing mechanism, said Walter Boettcher, chief economist at Colliers, a veteran of several recessions.
“Looking back feels stable, looking forward feels more uncertain, although the smart money is looking past short-term volatility,” said Boettcher, who is still (just about) happy with the idea that inflation is a short-term phenomenon.
“But there is a mismatch in expectations, we’re at an awkward moment for those tracking yields and rental growth expectations to determine the viability of investments,” he said. “We’re at a turning point where expectations are heightened, and it all depends how high interest rates go and the effects on property pricing. The question is should investors be defensive now, or be opportunistic ideally without leaps of faith.”
Boettcher’s conclusion — for now — is that looking forward probably offers more insight than looking back. But he’s far from certain. Because who knows what’s hurtling toward us?