23rd March 2020
We are living in truly unprecedented times. Over the last few days and weeks I’ve had a number of conversations with investors, borrowers and lending partners – about equity markets, property and, of course, Coronavirus. I wanted to share some of those conversations and my thoughts with you today.
** Your Capital is at Risk ** This is not investment advice
Will the property market mirror the collapse in the stockmarkets?
Historically, property has been more defensive than stockmarkets. Unlike stocks, property is not used solely for investment – it also serves an essential need for shelter.
Property does not have the same liquidity as stocks which makes it difficult to know how the market is moving in real-time. We will have better data in the coming months but, for now, we can use recent major downturns as a guide.
During the credit crisis, the FTSE declined 43% from peak to trough. UK property prices “only” declined 19% from a peak in Sept 2007 to a trough in March 09 (Land Registry transactions data). This is data for the UK as a whole and performance across cities varied. Interestingly, the London peak-trough was -18%.
We have no idea if, or how much further, the FTSE will fall but based on this basic analysis, a 10-20% fall in residential property prices could be expected as a base case. It should be noted that the 2007-09 credit crisis involved different dynamics – not least, an almost-complete collapse in the banking system. So far, we have not seen the latter yet.
Which sectors of property will be impacted?
The defensive sector is vanilla residential buy-to-lets. Valuations (and rentals) will be more impacted in commercial sectors (retail, office, industrial). The biggest hit currently is in the hospitality sectors (hotels, restaurants). Serviced accommodation (short lets) will also be negatively impacted – unless those units can easily be turned into residential long lets. The virus will eventually fade away but it will take time for these sectors to recover.
Late last year I wrote an about residential vs commercial investing, showing how commercial valuations are negatively impacted by macro events. You can read that article here.
How will Secured Loans be impacted?
One of the reasons i have favoured investing in Secured Loans is due to its asset-backed security. As long as the underlying property market does not suffer an out-sized collapse, the majority of such loans have security worth in excess of the amount lent.
The majority of loans i have invested in have a loan-to-value below 75%. Importantly, I always measure LTV% using CURRENT DAY-ONE values – not on GDV future value. Along with the sensitivity analysis i conduct, this ensures that potential valuation declines (like 2007-09, and now) are already factored into the analysis at the outset and would still expect zero capital loss.
Having reviewed the loans i have invested in, and shown to other investors, i currently expect no capital losses. There exists sufficient equity and security buffer to protect lenders.
There are some investors who have exposure to other loans that i am not involved in. I have been asked about their sensitivity. The below types might be more at risk in the current environment:
- Equity investments in developments (Equity carries no security backing and investor returns rely on development profits which are sensitive to GDV)
- Large schemes of 20+ units reliant on large-scale exits (reduced transaction levels may put such exits at risk)
- Projects where there remains significant construction until completion (requires ongoing development funding from lenders which may be at risk now)
- Projects that have multiple phases (they require ongoing funding and unit sales for cashflow needs to complete)
- Commercial/hospitality-use sectors (as explained above)
- Projects with low profitability ratios (GDV declines will have large sensitivity on profits)
- Investments with high LTVs or even negative equity on day-one (i.e funds raised were in excess of day-one site valuation)
If any of your investments sound like the above, please seek updates.
How will my loan selection criteria change?
My analysis has always been at the more cautious end of the risk spectrum. Given the uncertainties we currently face, and until we regain some visibility in the market, my focus will be on the following criteria:
- High quality, low risk deals (primarily driven by modest LTVs, low development risk and vanilla properties)
- RICS valuations that were carried out recently – ie after CV started taking hold (this provides more relevant valuations – which i would then adjust further)
- Higher Profitability ratios (measured by profit/GDV and profit/Cost ratios)
- Crystal-clear and vanilla exit strategies (eg avoid larger construction/conversion projects, favouring smaller resi refurbs targeted at end occupiers)
- Tight sensitivity analysis to factor in today’s market environment
Has the Stockmarket bottomed?
I don’t know. Market volatility will be news-flow related, dependent on lockdowns, new infection announcements and changing timeframes for a vaccine.
In the investment banking world, there is an ancient proverb that goes “He who tries to pick the bottom … gets a smelly finger”! Seriously, having said that, stocks are getting to “interesting” levels that could warrant thinking about bottom-fishing.
Stocks *will* reach a bottom – we just don’t know precisely when. Of course the big unknown is how bad CV gets.
In preparation I have put together a “hunting list” of stocks. I have divided it into three categories: 1) High dividend stocks 2) Higher quality stocks and 3) Bombed out names. Note that i don’t have in-depth knowledge on all these stocks – this is a quantitative exercise and does not equate to a recommendation to buy.
1. High dividend stocks
I like dividend stocks because, although we don’t know when the bottom will be, higher dividend stocks pay us handsomely while we wait for that recovery. More so now. Based on historical trends, many such stocks will eventually make good capital gains. The risk is that a number of these companies may be forced to reduce their dividends, due to the economic environment. Another risk might be that some do not even survive. As such, a diversified exposure of several names rather than just one might be sensible.
– See the list of stocks here. My screening looks for large-cap UK stocks with a minimum 6% dividend yield and max 15%. Plus a solid balance sheet to support some dividends.
2. Higher quality stocks
Higher quality companies are more likely to survive economic stress. They may not be the best dividend payers nor have the lowest valuations but they have a higher survival rate. And still they have sold off massively. This strategy is based on a sustainable business model and eventual capital gains once CV fears have stabilised.
– See the list of stocks here. My screening seeks large cap UK stocks with solid balance sheets, low Beta, decent ROE and low volatility of earnings growth.
3. Bombed-out names
These are companies whose stock prices have been crushed in 2020-to-date. Perhaps due to serious concerns about their survival in the face of CV and an impending recession. These are not necessarily high-quality names, nor high dividend payers. But if we have any good news on CV or the economy these names can be expected to outperform everything else. Beware: these are risky stocks. They could be very volatile and have collapsed because the market has questioned their survival.
– See the list of stocks here. My screening simply looks for mid-large cap UK stocks which have declined by more than 50% in 2020 so far.
Final words
Easy to say, but don’t panic. This crisis will stabilise eventually. If it doesn’t – and therefore becomes a threat to our civilisation – then making investment decisions will be the least of our concerns. Also:
- Stay diversified – across various asset classes
- Don’t get seduced by clever marketing or promoters that look/sound “credible”. Ultimately, it’s all about the hard facts, real security and evidence. Not words or feelings
- Have a read through my other articles on www.InvestLikeAPro.co.uk
And most importantly, stay healthy and safe.
Regards,
Manish
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