RealTMOR Asset Mgmt LLC and RealTMOR Apartment Mgmt LLP
Going forward, there is significant risk of slowdown in price increases of various asset classes with a possibility of price decreases. Looking ahead there seem multiple headwinds, which have been detailed by many commentators. Some looming risks for US real estate markets include rising US interest rates (higher mortgage rates), low affordability/high prices and swift price gains of residential properties, among others. Equity markets face Fed tightening risk, a potential Trade-war, slowing global growth rates (in Europe and Asia), oil price volatility, potential decreasing corporate earnings growth, yield curve inversion and potential corporate debt strain, among others.
Investors are facing challenging times and how should HNIs (investors with investible assets of $1mm to $30mm) prepare for such a scenario? This write-up is geared more towards HNIs at the lower end of the range, referred to as “HNIs” ($1mm-$10mm in investible assets).
DO NOT BE OVEREXPOSED TO ONE ASSET CLASS:
Diversification is the Holy Grail of optimal investing. Most HNIs tend to be over-exposed to either real estate (excluding the house one lives in) or equities. There is no “theoretical” optimal ratio but having a good asset mix is critical. Many Asian HNIs, especially in China and India, are over-exposed to real estate investments, often with leverage. Many US HNIs, tend to be over-exposed to equity and may have a highly levered real estate position. European HNIs tend to sacrifice returns for safety and tend to be concentrated towards fixed income investments.
All assets have cyclical price dynamics, real estate has longer cycles while equity has shorter cycles. ALL ASSETS have BULL and BEAR markets, at times bear cycles between real estate/equities don’t overlap. Over-exposure to an asset class during a falling cycle magnifies losses and creates financial distress.
DO NOT BE OVEREXPOSED TO ONE GEOGRAPHIC AREA:
Most HNIs, tend to be over-invested in their country of origin/residence whether its equity, real estate or fixed income investments, or a combination. Concentration may actually be in “home country” real estate holdings. Most own an investment property in the city they reside in or a second “vacation” property in proximity to the area of their residence. For most such investors, their primary income generation mechanism also happens to be in their country of residence/origin.
Being concentrated in one economy or geography leaves one vulnerable to local economic or local asset cycles. A pullback in the local/national environment could create financial pain at multiple levels and potentially create irreversible losses. Further, geographic concentration (more acute for emerging markets HNIs) heightens currency risk. A fall in the primary currency during a local economic contraction magnifies deleterious effects (happened in Russia post 2015).
ADEQUATELY ADDRESS EXCESS LEVERAGE
Debt significantly increases returns during a “bull market” but significantly increases pain during a “bear market”. High exposure to margin loans or multiple mortgages on the primary residence or multiple investment properties with large mortgages could easily create financial distress. In many high priced markets such as Hong Kong, Sydney, Vancouver, Mumbai etc., many investors own real estate with negligible or low monthly cash flow. They bank on out-size forward capital gains for profits.
When asset prices retreat, the equity component of the levered asset decreases and the “value” of the asset to the investor quickly erodes. During economic stress, there is a higher probability that vacancy rates increase and cash flow generation decreases. This creates untenable debt burdens resulting in lenders making decisions that could hurt the ownership of the asset (foreclosures, liquidation of margin accounts etc.).
ENSURE UNDUE RISK NOT UNDERTAKEN
Not all returns are similar, it is critical to receive returns comparable to risks undertaken. Maintaining sight of the risk/return balance is key and focus on “absolute” returns alone is wrong. This thesis has been addressed well for equity investors by commentators, recommending MFs or ETFs v. individual stocks or Blue-Chip stocks v. small caps etc. Regarding real estate, investing in funds or projects involving development of condominiums or hotels or student housing is inherently much riskier than investing in traditional income generating residential assets. Such projects involve taking on “development” risk which is the riskiest area in real estate. Further, investing in segments (e.g. UK Student Housing, US motels etc) includes risks that involve that particular segment/operations over and above regular real estate risk. HNIs often focus on “absolute returns” and ignore the risk undertaken.
Above-mentioned riskier real estate assets potentially experience a downturn sooner and more significantly during bad markets. Investing in such assets purely for the “absolute returns” without fully embracing the risk could be problematic/detrimental in tough times. Such investments are less liquid and recover prices later than traditional income generating residential properties.
MAINTAIN LIQUIDITY AND ENSURE MEDIUM TERM CASH NEEDS DON’T ENTAIL SALE OF ASSETS:
During times of plenty, there is a tendency to be “well invested” and most HNIs put available cash to “good use”. There is a common market adage, “the fear of missing out”. As asset prices scale higher levels, the feeling of “positive continuity” sets in and investments are favored over “safe” cash balances. Also, there is a tendency to pay higher prices which has further detrimental effects on cash balances. This situation could worsen if there is a genuine medium term cash need and sale of assets becomes inevitable in low price or low liquidity scenarios.
Maintaining adequate liquidity is a must for situations requiring short to medium term cash flow needs such as tuition fees, large anticipated personal/business expenses. Even in good times, distress sale of assets results in poor price realization. In bad times, this is magnified to one’s detriment. Hence, it’s better to sacrifice some short term returns at the altar of prudence. Adequate liquidity also helps if the situation creates buying opportunities of good assets.
DO NOT PANIC SELL OR MAKE PURCHASES AT THE FIRST SIGN OF A PULLBACK:
There is a common belief, with some truth, that individual investors see “opportunity” and “danger” somewhat later than the institutions. Hence, during a swell of negative trends the smaller investor tends to go into “conservation mode” and exits the market (construed as “panic selling”). Another, common phenomenon is “buy the dip” which in a long or severe “bear market” could be trouble. Investors see a small price drop of a coveted asset, be it a condominium in New York, London, Singapore, Mumbai, Toronto, Miami, Dubai etc. or high flying stocks like the FAANG stocks and grab at the “discount”. There could be further pain for that asset from that initial “discount”. Hence, either phenomena, “panic selling” or “premature buying the dip” could result in painful outcomes.
Panic selling results in “unrealized losses” becoming “realized losses”. For most high quality assets (bought at appropriate valuations), there is a good chance of price rehabilitation once the cycle passes. Further, even quality assets bought at very high/unsustainable values have a risk of price correction for prolonged periods. The more unreasonable the price at the highs the longer it will take to get back to those levels. Hence, small discounts at the start of the bear cycle may end up being severely negative in the long-term.
An HNI should be diversified owing real estate, equities and fixed income assets. Owing an adequate amount of residential real estate, across geographies, which is income generating and has appropriate risk/return profile is a key exposure for HNIs. HNIs from developed countries (USA, Australia, Canada, EU, East Asia) SHOULD NOT MISS the opportunities afforded by emerging markets and should have that exposure because of their growth potential. HNIs from larger emerging markets (China, India, and South-East Asia) absolutely need the safety and stability of the developed market assets in their portfolio and SHOULD HAVE that exposure. HNIs from other countries (Russia, South American Countries, African or Gulf Countries) SHOULD HAVE exposure outside of their home markets. They would need exposure to both developed markets and the dynamic emerging markets. Having exposure outside of one’s home country also allows one to implicitly hedge against currency risk which is essential in the current “global” environment. Equity markets in most countries outside of the US are not very deep or stable and hence real estate investments in foreign markets should be viewed as preferred investment routes.