There’s a quiet market… and then there’s a totally dead one

August is generally quiet. This August was beyond mind-numbingly barren, a record breaker and a stark reminder that we investors inhabit a world that can undermine convention and demonstrate that, as much as we believe our assets have real value, there are periods when aspiration and reality can be light years apart.

When investment markets are as anaemic as they are right now, one usually expects to see the bottom fishers feeding off the bankrupt, outcast assets, but, if it is going on, it is doing so on such a small scale that it is barely registering.

One thing about having plenty of grey hair is that you recognise the markets work in cycles, but you also understand that the cycles are never quite the same. If it were that simple, we would all be billionaires. So, what is it that we are currently experiencing, because it doesn’t look or smell like anything I have experienced in four decades of real estate investing?

Shock and awe

Anyone who started their career in the immediate post-GFC era will probably be around 40 years old today, so they will have only experienced a period where, for reasons behind the salvation of capitalism as we knew it, debt became almost free. As a direct result of quantitative easing (QE), asset value accretion was breathtaking.

It is not a shock when yields are 6% and debt costs 1.5% that the money tree keeps giving. However, some investors created huge amounts of wealth almost by accident and, it transpires, are not the geniuses they thought they were. They certainly didn’t recognise that just as money supply can be eased, so too will it inevitably need to be tightened.

Economists warned at the time of the GFC global rescue mission that the ultimate price of QE would be seriously asset price inflation and that interest rates would have to rise dramatically to control it. For many years, they were ignored and so we all became too comfortable.

Then the black swans arrived. With a helping hand from Liz Truss, the pandemic, Ukraine war, energy crisis, ESG obsession and super inflation sent us into a financial tailspin, the net result of which has been interest rates several hundred basis points higher than we were used to.

The first casualty was valuation, with 20% to 25% write-downs almost overnight. These did not necessarily cause LTV breaches, but they were sufficiently scary to make lenders crawl all over their loan books and pull up the drawbridge to new business, precipitating further value destruction. Floating rate debt, moreover, became a profound problem with ICR breaches proliferating.

Having learned lessons from the GFC, the market is lower leveraged, so equity cover has been less of a challenge. It’s the ICR covenants that are the ‘problem children’ today.

This is a wonderful opportunity for lenders to strip out the economics from borrowers.

To cure the problem, borrowers need to invest more equity and receive less net income. No one likes those metrics very much, but if they don’t accept this new reality, the investment could soon be worthless to the borrower, but not lender. The opportunities for very expensive mezzanine lending are clear.

To the younger less experienced investor, this has all come as rather a shock, with many thinking that come September, they will start solving the issue by selling their problem stock. Group think will ensure the market becomes flooded with stock and pricing could come down by another 10% or more before we start to see any stabilisation, especially in the non-vanilla assets.

Working from home

We have a new generation of worker, who because of full employment has become very used to walking into jobs – and walking out very quickly if something about the work or workplace doesn’t please them. Loyalty is not currently a common character trait.

Inexperienced employees today seem to have a very high sense of their own worth because jobs are easy to come by. This will change and WFH is part of the problem.

Employees deserve to be well looked after and the best companies enjoy the highest staff retention because they offer more than the average. However, one of the most common demands of the office worker today is not to be an office worker at all, but to work from home. In the post-Covid era, tech companies in particular joined a sprint to the bottom in terms of allowing employees to work mostly from home. This, unsurprisingly, was quickly reversed with hybrid working the norm now.

The big mistake many employers are making in their quest to get staff back to the office is that instead of offering great surroundings and a home away from home, they have reverted to dreaded hot desking and are treating staff like battery hens in an attempt to cut costs.

“Stuff em in” seems to be the order of the day, rather than using the physical environment to build creativity. My advice to CFOs and CEOs is that you will not bring staff back to the office unless you make it a genuinely great place to be.

Looking ahead

I am pretty confident that in spite of the above challenges and the practical realisation that EPCs will NOT work in their current form, we will get through this tricky period sooner than many commentators predict. But blood will be spilt. Many failed refinancings will generate opportunities for the cash rich to pick off the deals that in the future, we will look back on and say: “I wish we had done that one!” It was ever thus.