What’s Next For Global Real Estate?

By Chris at www.CapitalistExploits.at

Market dislocations occur when financial markets, operating under stressful conditions, experience large widespread asset mispricing.

Welcome to this week’s edition of “World Out Of Whack” where every Wednesday we take time out of our day to laugh, poke fun at and present to you absurdity in global financial markets in all its glorious insanity.

While we enjoy a good laugh, the truth is that the first step to protecting ourselves from losses is to protect ourselves from ignorance. Think of the “World Out Of Whack” as your double thick armour plated side impact protection system in a financial world littered with drunk drivers.

Selfishly we also know that the biggest (and often the fastest) returns come from asymmetric market moves. But, in order to identify these moves we must first identify where they live.

Occasionally we find opportunities where we can buy (or sell) assets for mere cents on the dollar – because, after all, we are capitalists.

In this week"s edition of the WOW: global real estate

Ever since anyone can remember, global real estate prices have been going up. Pretty much doesn"t matter which country you"re from (unless, of course, it"s Syria, or Iraq... or Fuhggedistan): if you bought something in the last 2 to 3 decades, it"s like the ceilings were insulated with helium. Even when the 2008 crisis hit and we had Captain Clever ensuring the world that things were just peachy:

"At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained. In particular, mortgages to prime borrowers and fixed-rate mortgages to all classes of borrowers continue to perform well, with low rates of delinquency." - Ben Bernanke, March 28, 2007

Even with that setback real estate has marched upward. The US, of course, took a decent breather and is only today back to where it was pre the GFC.

But the US isn"t the world, so let"s look at what everyone else has been up to.

Take a look at this:

In the British empire and all its former colonies the inmates pretty much trucked on after a short "uh-oh" moment:

"Did you see that Bobby? Blimmin Mary reckons the place down on the corner only fetched a million quid."

"Musta been a steal laddie, it even had a fence. Reckon we ought to get out and buy already."

And so they did as we can see.

In truth, it hasn"t just been Mr. and Mrs. Smith in their tweed coats buying up UK properties, just as it hasn"t been Sheila and Bruce in Sydney, or even Maple and Hudson in Canada. A significant amount of buying power in these markets has come from offshore buyers, largely frightened Chinese money being parked. It"s pretty extraordinary, really.

Prices alone don"t provide us with the entire picture or provide us with context. I mean, real estate prices in Harare went through the roof, too, in the 2008-09 period (in ZWD) but the currency went through the floor and real purchasing power collapsed. Context, therefore, is important.

Also, clearly a swanky penthouse in Manhattan overlooking the Hudson river shouldn"t be priced the same as a swanky penthouse in Vientiane overlooking the Mekong. The main difference? Incomes.

So let"s take a look at prices relative to incomes for a better understanding.

Buying a house in the US actually makes a lot more sense. Certainly relative to its international peers the US is cheap. In fact, if you factor in the ability to fix debt for a ridiculously long time in a currency that"s ultimately going to get hammered, and if you need to find somewhere to live then you"ve found a way to essentially be synthetically short the bond market (provided you fix your rates). I"m not advocating this as a strategy but merely pointing out the mechanics of the trade.

As investors we"re interested in viewing real estate as we would any investment or asset, and as such understanding the cashflows is important. Naturally, incomes relative to asset prices tell us what the owner"s cashflows are relative to the asset they"ve buying... and the same analysis can be conducted against student loans, car loans - any credit instrument, really.

Here"s rents (cashflows) relative to asset prices:

Oy vey! There"s enough there to make your hair stand on end.

What do you think the cashflows on this baby are like?

I wonder if it comes with free tetanus shots?

Spotting bublicious markets is one thing but it"s quite another identifying turning points and then another altogether finding a means of constructing an asymmetric payoff.

Here"s a question to ask yourself:

What happens when cap rates go from 4 to 6 as in the US and from 5 to 8 in a place like New Zealand? I think we"re going to find out over the next few years.

Napkin Math

Let"s do the math...

We"ll keep the numbers dead simple. It"s the same math as looking at the market cap of a company and its dividend yield and free cashflows.

So we"ve got an asset, a commercial building someplace priced at $1m with a 4% cap rate, thus yielding $40k, and let"s assume financing costs at, say, 4%. Now this mythical building could be in Toronto, London, Sydney, or Auckland. And yes, I know financing rates and cap rates differ across town let alone across countries but it doesn"t matter - the same principles apply.

Now, for the guy owning this asset he"s either:

1. Levered and using the $40k to service debt, or...


2. He"s simply allocating capital and the 4 cap rate was more attractive than the 2 he"d get on a CD.

You may ask yourself the question: Why on earth would an investor buy a 4 cap asset in an environment where financing costs are 4%?

After insurance, maintenance, any tenant vacancies, and other opex you"re definitely underwater. A great question and one that many investors are going to be asking themselves while staring in the mirror at some point in the next few years.

The answer actually lies not in math but in human behaviour and expectations.

When rates continuously moved lower and then lower still as coordinated global central banks held rates down, buying in anticipation of ever cheaper financing costs made a lot of sense. Plenty people have gotten very rich doing it over the last few years.

Even just a 25bp move on debt financing on a multimillion portfolio of assets translates into a a heck of a lot on the asset price revaluation. And what"s more is that the guys buying negative yielding assets woke up a few short years down the track to a situation where cashflows had turned positive (financing costs moved lower) on top of the price appreciation which has been enormous. That"s how leverage works and that"s how linear assumptions get made well into the future.

Now let"s get back to our story and say lending rates rise by 200bp to 6%. The market will immediately begin to reprice all assets, including our mythical commercial building.

What are we prepared to pay for this place in a 6 cap environment?

Our interest expense just went from $40k to $60k - a 50% increase.

$40k of income used to service $1m of debt but at a 6 cap it only services $666k - a nice 33% equity haircut.

Except, of course, that"s not at all how markets work.

They are forward looking, and so when the market finally figures out that financing costs (rates) are heading higher not lower for longer, then they begin pricing in this reality and cap rates go higher than financing costs, sometimes much higher. What happens to the equity? My guess is we"re going to find out.

On Friday I"ve got a follow up article from a good friend of mine, which gets into a particular sector of the market where this is likely to hit hard.

- Chris

PS: I normally have a poll on the WOW and today I don"t. They say a change is as good as a holiday, plus I"ve gotta keep readers on their toes.

Oh, and if you like... no, love Capitalist Exploits, then please share it with every man woman and child you know. I"ll love you even more.

"There are decades where nothing happens, and then there are weeks when decades happen." — Lenin

--------------------------------------

Liked this article? Don"t miss our future missives and podcasts, and

get access to free subscriber-only content here.

--------------------------------------

Raoul Pal Warns The Day Of Reckoning Looms For VIX Shorts: "Reminds Me Of Portfolio Insurance In 1987"

ubmitted by Patrick Ceresna via Macrovoices.com,

In a podcast interview on MacroVoices, Macro Guru Raoul Pal makes some comments on some of the biggest imbalances in the markets today. 

He compares the VIX contango trade to the portfolio insurance problem that was blamed for the 1987 crash...

• they don"t realize the rate of change of the VIX can be so extraordinary that the losses can mount up massively and super quickly

Pal then goes on to discuss the record level of speculative long positions in the oil markets compares to the conditions in the summer of 2014 prior to the bear market decline

• The other thing was speculative position in crude oil was all time high in fact if I took the trend going back from the early 80"s it was seven standard deviations above that trend and well over three standard deviations maybe four standard deviations from the trend in the last 20 years or 15 years.


• I"ve seen a similar situation with copper driven by China and a few other things where copper position is wildly extreme and so I start to think well too much reflation is priced into these things maybe there’s an interesting opportunity on the short side


• What is interesting oil volatility has been coming lower. Look, I don"t think it"s going to get back to where it was in 2014 when it was trading below 20 but it has come down from a peak of 80, a kind of a real trading range of 50 down to 30. If it comes any lower the ability to buy options start to make sense because oil volatility can go to 80 can go to a 100

Full podcast:

Excerpts of the interview:

Erik:                One of the risk factors that we discussed last time was this crazy VIX contango trade where basically people are shorting VIX futures because each time they roll that contract forward they capture the contango by being short and they see it as a way to produce income. Of course, you know that"s not just picking up nickels in front of a steamroller, that"s pennies being pried out from under the steamroller and so far a big downdraft in equity prices has not happened which was the big risk that you saw there. You described how if there was a sudden downward move in equity prices it could really blow up in these guys" faces. Is that risk still in the system, is that trade still on or have people wised up and gotten out of it?

Raoul:             No, that trade still goes on to this day and it reminds me a lot of the portfolio insurance stuff around 1987 or some of the kind of spread trade Low Vol trades that happens around 1998 people go over their ski tips with this stuff. They think it"s all manageable and they think that OK we can sell VIX and if we lose money on that, we"ll use this as an opportunity to buy stock because we"ve been taking in premiums but they don"t realize the rate of change of the VIX can be so extraordinary that the losses can mount up massively and super quickly.

So, I worry about that position. I worry about a whole world that sets up for low volatility when you"ve got a new administration that is almost unquantifiable. We don"t know what kind of volatility should be under an administration like this but a relatively aggressive administration should create more volatility overall so at which case the generalized level of volatility should rise.

If the past 20 years of global historical data is anything to go by, that "awakening" of uncertainty is very bad news...

Erik:                Well I’ll see if you want to grade me on the thoughts I have. The only real directional trade that I see right here is long the dollar index and I think we agree on that we"ve already discussed the reasons why.

Beyond that the things I"m looking at there, if I look at the term structure of crude oil. We"ve got a fairly steep contango for a few months but then we see backwardation in the belly of the curve. So apparently, we"re not going to need storage after June or July or so it"s going to be a non-issue those tanks are going to be empty. I"m not buying that story.

So I do see a curve steepener trade that is-- I actually just bought a bunch of spreads short June, long December. Just thinking that at that point there was backwardation in that segment of the curve I don"t think that"s going to stay in backwardation I think by the time June gets here we"re going to be looking at contango again.

So that"s one trade that I see the other one I"m kind of waiting for and I’m lining up quite a few dominoes here is I think that Trump is going to get tough with ISIS very quickly after entering office and I wouldn"t be surprised if there"s some kind of ultimatum, ISIS knock it off or else, and I think there"s so much hysteria right now politically there"s so many people with such polarized viewpoints that you could easily see a an overreaction, a massive upward spike in oil prices because a lot of paranoid people are convinced that Donald Trump is going to launch nuclear weapons on ISIS or something.

I don"t think that"ll actually happen. If there was a $25 up spike in oil prices from here I would look at that as a very very ripe shorting opportunity because I don"t think prices can go $25 higher and stay there because the shale revolution will be restarted, the bakken will be relaunched and those prices will come back down.

So I don"t want to bet on the up spike I"m not convinced it will happen if it does happen I"ll definitely bet on the mean reversion. Frankly that"s all I can really see at this point for trades.

Raoul:             So to add on about oil. Oil is interesting to me because if you remember I made a very public forecast on oil way back in 2015 I think it was, when I said look I think oil is going to fall to $30 dollars a barrel it was like at 110 at the time and luckily it got there these things don’t always work out that way but it did and the reason I had a lot of faith was twofold one the dollar was going up and I thought it would go much higher which obviously is the normal nature of oil prices so that helps that.

The other thing was speculative position in crude oil was all time high in fact if I took the trend going back from the early 80"s it was seven standard deviations above that trend and well over three standard deviations maybe four standard deviations from the trend in the last 20 years or 15 years. So, the position was huge.

If I look at it now again, I"m looking again at my Bloomberg screen as we speak it"s equal to where it was. So, it came, all the way back down, it"s got all the way back up. So, the market is wildly gigantically bullish on crude oil and that is something that starts looking like an opportunity to me on the short side.

I get what you"re saying about the price risk which is always the danger of shorting crude oil it"s always a bit of a negative gamma trade. So it makes it a bit nervous but I still think that crude oil comes lower so I’m bullish in that.

I"ve seen a similar situation with copper driven by China and a few other things where copper position is wildly extreme and so I start to think well too much reflation is priced into these things maybe there’s an interesting opportunity on the short side.

Erik:                Yeah, I very much agree with that I want to be short equities here and I want to be short crude oil but I don"t dare to touch either trade from the short side right now because there"s been so much bullish hysteria in the equity market. I don"t know what"s going to happen to you know sell the inauguration. OK I"ve said sell quite a few times in the last few years and been wrong so I want to be short but-- emotionally I want to, I can"t bring myself to do it because there"s just been-- every time I say OK the market can"t possibly go higher than this it ends up going higher.

In the case of crude oil, I"m convinced that this rally has played out from a fundamental standpoint. It’s that hysteria risk that if it happens it"s a fantastic opportunity to go short. I would consider puts on crude oil here as a speculation that maybe they"ll go lower. But I don"t want be an outright futures here I"d rather be in puts on futures and have a very limited downside if Trump scares everybody.

If that happens – I don"t think it"s a real risk – I just think it"s hysteria and look at there"s actually been an increase in residency applications in Chile because there are people freaking out about Donald Trump so much that they want to be in the southern hemisphere for when he starts the nuclear war that"s a fact. This is hysteria and until it settles down I don"t want to be on the short side of the oil trade unless it"s using options or something protected.

Raoul:             Yeah, I agree. What is interesting oil volatility has been coming lower. Look, I don"t think it"s going to get back to where it was in 2014 when it was trading below 20 but it has come down from a peak of 80, a kind of a real trading range of 50 down to 30. If it comes any lower the ability to buy options start to make sense because oil volatility can go to 80 can go to a 100 so maybe buying some puts on oil or you buy kind of out of the money calls out of the money puts If you"ve got the view that you have that there is a tail risk events of something that Trump administration will do to drive up the price of oil and that"s possible don"t forget that the economic policies is credibly pro oil in the U.S. right now with the new administration. So, it is in that economic interest to drive up the price of oil.

So yes, I can see that too. I love these kinds of puzzles. These are the kind of ones that get me up at night thinking wow, that’s interesting, you"ve got all of the reasons why the oil price should fall, all of the geopolitical reasons and business reasons why the U.S. wants a higher oil price so how does this play out what does that mean for us.