CoStar Guest Column: L&G warns of falling secondary markets
By Robin Martin - Monday, October 17, 2011 11:25
In the face of economic uncertainty across the Eurozone, Robin Martin, Legal & General's head of performance analysis and research, looks at likely scenarios across the UK commercial real estate industry, and considers the likelihood of a 15-20% fall in values across certain markets.
In July, we flagged up the potential for a growth scare to weigh on UK commercial real estate. That potential has become reality. But it has been made more acute by the Eurozone sovereign / banking crisis that has added new and toxic ingredients into the mix.
How can we respond against the backdrop of such extreme uncertainty?
We are believers in the value of scenario analysis.
This is often applied as a largely descriptive exercise, setting out different potential outcomes.
For us, the real value is in isolating how one would actively manage portfolios differently under each scenario and designing strategies which are adaptable.
In developing scenarios, focusing on the most extreme outcomes often yields the most useful results.
What are the key risks?
Unfortunately, there are a range to choose from, the vast majority on the downside. But it is difficult to avoid focusing on the Eurozone. Greek sovereign default is increasingly a case of when not if. French banks alone hold $53 billion of Greek government bonds. Eurozone banks are increasingly wary of lending to each other, in conditions reminiscent of the darkest days of the financial crisis in 2008.
These headwinds encouraged the Bank of England to commit to a further £75 billion of quantitative easing.
Scenarios
Legal & General Investment Management (LGIM’s) economics team expects the Eurozone economy to weaken sharply in the coming months. Political strains are already apparent and elections in all the core Euro members over the next 18 months will further increase the chances of a restructuring of the Eurozone.
What form these might take remains speculation.
One possibility is a split into northern and southern groupings, with the southern grouping encompassing those countries that are currently the focus of sovereign credit concerns. In the short-term, this would likely push these countries into severe recession; outside of the umbrella provided by the core northern European markets, these economies would be exposed to much higher interest rates.
Nor would the north escape the impact; severe recession in the south would bear down on demand for northern Europe’s goods and services as well as creating further strain on banks with exposure to the south.
As the UK’s largest trading partner, problems in the Eurozone threaten the export and investment-driven recovery that the UK is aiming for. But from an investment perspective, the UK is clearly benefiting from the perception that it is a safe haven within Europe; the government has a clear strategy for reducing the deficit and there is no sign that markets are losing faith in the UK sovereign credit rating.
But the problems in the Eurozone will undoubtedly make it more difficult for the coalition to follow the course they have set. Their expectations for private sector expansion were always optimistic – they are now almost certain to be disappointed. There will be increasing pressure on the government to adopt some sort of ‘Plan B’ and to use their buying power to support activity and jobs.
That would create the risk that the UK becomes the target of the same sort of speculation that has afflicted other countries. This would likely lead to a sell-off in gilts, higher borrowing costs and a sharp devaluation of Sterling.
The LGIM view is that this scenario, by virtue of the seriousness of its potential impacts, has a very low probability. But it remains a tail risk that a robust strategy will take account of.
Impacts
We have a high conviction view that weakening economic prospects and the appetite for safe haven assets will lead to a re-emergence of the preference for high-quality, low-risk UK property assets; with gilt yields low, we could even see price appreciation for the best product.
But mirroring the sharp pullback in risk appetite in fixed income and equity markets, we could easily see values for high-yield, high-risk assets fall by 15-20% over the next six -12 months.
A scenario in which investors lose confidence in the role of the UK as a safe haven would be qualitatively different. Required rates of return would rise across all tiers of the market, much as they did in 2008, with little differentiation for quality.
In that situation, real estate outperformance would rest to a large extent on defensive income preservation and a lack of exposure to leverage.
Red flags
In our view, the most severe scenarios in which the UK loses its safe haven status will be avoided.
UK gilt yields remain well-behaved and Sterling interbank spreads, though up slightly, do not suggest any significant contagion from the Eurozone banking system into the UK. On the other hand, Euro interbank spreads and the cost of insuring against bank default have spiked.
With every day that passes without a solution that reassures the markets, the likelihood of some form of disorderly outcome becomes greater.
Bottom line
We are optimistic that the UK market can escape significant value declines at the all property level over the next 6-12 months. But the probabilities of extreme downside outcomes have increased and fund strategies need to be able to adapt quickly to changing conditions.
Those that do will give themselves the best chance of being able to capitalise on the inevitable opportunities that market volatility creates and insulate themselves from risk.
Robin Martin is head of performance analysis and research at Legal & General Property.