Back to basics and looking for a new equilibrium

balanceSo, the crisis brought us back to basics. Two feet in the mud, looking for what really matters in real estate investing: a solid cash flow, or, as you may call it: the quality of the income stream. That is key, but we seem to have forgotten about rental values, ERV, or the tenant in the first place. For years, property investors (and financiers, for that matter) have been gazing at capital value growth and yield shifts, in the apparent total absence of reason and logic.

And now, back on earth, we are looking for a new balance. Looking for the right price for the amount of risk we are willing to take up. Easier said than done, now that the world is completely different than 12 months ago (is it really? yes, it is). Investors need to adjust to new market circumstances and conditions. Low interest rates, high risk of defaulting tenants, high vacancy risk, questionmarks at rental values and also still questionmarks at financing.

One of the results is that we see yield gaps widening to increasingly attractive levels. Over the past few weeks, I have seen some high level transactions taking place, in well-established markets like London, at net initial yields around 10 percent. I will list a few of them, shortly. Bearing in mind that lending has become cheap (nice loan, if you can get it…), the yield gap has increased dramatically.

Yield gap is nothing else than a risk premium. So it must be the case that the actual risk of investing in property is high then? No, it has little to do with actual risk, allthough liquidity risk is high. It is merely perceived risk. In other words: the market perceives such high levels of risk that (purchase) prices should drop in order to maintain the same level or risk adjusted return. That is plain and simple economic theory put into practice.

Shrewd investors tend to think in the longer run these days. For these investors, today is the time to buy. Buy property at 9 or 10 percent yields, collect and improve the rent, wait until the sub-5 days return and make a nice exit. That is also plain and simple economic theory: buy low, sell high. Not the other way around.

A quote from AEW’s Ric Lewis (in one of my earlier posts):

It’s interesting to know what the spot price is and I understand that banks want to know what it is today. But tomorrow the property may be worth a lot more and most big investors buy a property for a specific holding period.

So true. And interestingly enough, AEW is one of the acquiring investors these days. Not surprisingly, at yields of around 10 percent…