Following a Skype interview, published on the BiTV channel in March, Philippe Le Trung, Founder and Managing Director of VIEWS+S Consulting, addressed below the risk premium for real estate, in the current Coronavirus pandemic.
Will real estate, which has been for the past ten years, along with private equity, the best-performing and most attractive asset class for savers and large institutional investors, continue to lead the race? We can put an end to the suspense right now, we don't have the answer, but we propose a new way of looking at the risk premium of real estate investment for this near future.
Health crisis, economic crisis, and financial crisis. The only certainty today is the unprecedented level of... uncertainty. The current context is marked by many human and personal dramas, but we cannot avoid the questions concerning the near future. What will this crisis change? What are the new behaviours of users? What are the economic impacts of this global shutdown? What will these changes mean for real estate? When it comes to real estate investment, two quite related questions arise: what is the appetite for the real estate asset class? At what price?
"A historically high risk premium over interest rates!" This has been the strongest argument for the past ten years. Indeed, since 2010, all analyses on the valuation of real estate investment have come to the same conclusion. Interest rates are low. The rise is not topical. The difference between risk-free interest rates —in France the OAT 10 - 10-year French government equivalent bonds— and the property yield —net rents/purchase price— is high. So we buy. Indeed, when we talk about a high risk premium, it is positive. When it comes to the best offices in the Central Business District, a high premium means a high overpayment. So, the higher the risk premium, the more attractive the real estate is. With negative long-term rates and returns close to 4% for very good assets in 2018, the risk premium for the best assets was at least 400 basis points. Never seen before!
We have never been completely convinced by this analysis. Two arguments make us cautious about analysing the attractiveness of real estate through the risk premium compared to long-term rates.
Firstly, rents are not paid by the State —like bond coupons, but by tenants who do not have the same financial strength. Indeed, they belong to different sectors, have more or less cyclical activities and are either large groups or SMEs. Therefore, when looking at real estate, one must take into account the tenant credit risk, which in the bond markets, is also measured with a premium. With a buoyant economic context and institutional investors, who are primarily interested in large signatures, this risk has been very low in recent years.
Secondly, real estate is a real asset which is subject to obsolescence, requires Capex, and has a residual value that is quite different from its investment value —unlike bonds redeemed at par. Note also that rents are indexed. All these elements are ignored when comparing a building and a bond.
New context, new rules
While everything seems to indicate we will enter a period of economic recession, interest rates will remain low, so why not keep it that way? High risk premium means attractive real estate for investors. End of story? Not really.
Of course, a first reaction is to introduce a new risk for real estate. With the coronavirus crisis, we observe incomes are less certain than initially envisaged. Faced with difficulties, tenants may defer or question rents, and the public authorities may even regulate a suspension of rents. This is a new risk, although exceptional and does not seem to us to put the value of real estate investments into question in the long term. We do not believe this is a structural reason for the price of investment property to change.
We think the risk premium will have to be analysed in a very different way in the near future.
On the one hand, the risk-free rate, the government bond rate, will not be as linear and predictable as it has been in the past. The titanic means implemented by central banks and not governments will result in large debts and consequently unorthodox fiscal policies. The country risk will increase, especially since a recomposition of the balances between major powers seems unavoidable in the near future. Thus, we are convinced the risk-free rate will be a less meaningful benchmark for real estate investment.
On the other hand, the coming economic recession will mechanically translate into issues of solvency and tenant resilience. The support of States wishing to avoid bankruptcies will not be permanent and the recession is synonymous with difficulties for businesses. In the near future, capitalisation rates will have to take greater account of rental risk, both credit risk and vacancy risk. This is certainly an element of new magnitude.
Price discovery
All these elements suggest a period of several quarters of price discovery. Risk-free rates will be less robust and may lose some of their relevance, which should leave more room for metric values, or comparisons with replacement values or developer balance sheets. The risk of default will have to be more anticipated. There is every reason to see a more pronounced spread in returns. Not to mention that, in the near future, we can imagine an acceleration in the introduction of new uses, resulting in shorter leases, more variable rents and an increased need for services. This is why we believe, as an indicator of relative valuation, the risk premium will be less relevant. However, looking at this risk premium will undoubtedly constitute a new tool for risk analysis and risk is a key to reading a world in crisis. The risk premium is dead! Long live the risk premium!
Source: BusinessImmo.eu