Those damn property funds… (are not to blame)

Property funds are not the problem, Central banks and Governments are.

It’s a common misperception that property funds are ‘driving up the prices of housing’, to make this analogy all you need is some housing dysfunction and at least one property fund to purchase anything and it’s game, set and match in the narrative sense.

What’s missing is the ‘why’. Property is an illiquid and immovable asset, if there were liquid movable assets with similar returns any fund manager would be hung for setting out to underperform with property (which has a million vagaries in taxation, upkeep and regulations to hold — unlike investment grade assets).

The ‘why’ is that Central Banks have set rates at zero, stock markets are at historic highs, Governments are happy with an era of low debt cost bond issuance and we have a lot of older people who need to be paid annuities.

When a Central Bank sets rates at zero (Zero Interest Rate Policy — ZIRP) it creates powerful and perverse incentives, one of which is to create a situation where leveraging up to the gills and going out to find yield becomes attractive.

The issue with leverage was/is/will be, that it just amplifies the results, if you leverage up and win you win big, if you leverage up and lose you lose your shirt.

A demonstration of how this works is by combining the search for yield, the market yield compression and property valuations as follows.

A fund buys a block of apartments that generates $100,000 a year and was bought on the basis of a 6% yield a few years ago (the price paid was $1.67m). They had borrowed at 2% in the market and are managing the difference.

Now rents have gone up 5% and other property funds who are scrambling to find yield are willing to buy the place at a 4% yield. Quick maths: (rents now $105,000 so divide by 4.5 and multiply by 100) and you have a sale price of $2.34 million.

That’s an uplift of 40% on the capital! Absolutely dizzying gains which can be obtained in a low growth economic situation where debt carries very low costs.

Hence the whole world and it’s brother are jumping in on that trade — not just in Europe or the USA but everywhere that this dynamic along with a stable government exists.

It suits Central Bank to play both sides and have a low interest rate environment while also saying they are suppressing house prices that would spiral out of control without their oversight, it’s strange though because they are creating the very ingredients that cause it and then blame every other party of the ecosystem. It’s like giving a person a fever then blaming the thermometer for it.

Governments are in the same camp, have you heard any politician or government of a nation anywhere say how awful it is that bond yields are negative? Is there anybody who says this is damaging?

Directly it isn’t, it makes being debt burdened possible and during Covid that has been a vital element of economies not tipping over — but to think that money everywhere wants to buy negative yield when you can repackage property into a debt instrument paying hundreds of times more is to ignore financial reality.

Whatever about negative yields, if you had the ability to get 0.01% on a large sum of money held as a deposit/debt or otherwise (imagine a pension fund that needs to get 1%+ return a year to stay going) then you are missing out on 0.99% a year.

Then along comes Joe Financial and he says ‘give me that money, I’ll buy a load of apartments and homes, package them up and it will give you 2% for the next 20 years guaranteed (and Joe either pockets the difference or farms it out or does a million other things) and presto. You’re back in the black.

This is why investment is flooding into housing, it’s a hot sector that was under-served during the financial crisis and it’s one of the only places you can get those returns (because of the sectoral compression), while also availing of cheap money and market momentum.

The expression ‘Don’t fight the Fed’ exists for a reason, but housing policy-wonks don’t seem to have that in their vernacular and suggest every manner of way in which to resolve the problem through one of several broad choices, each as ineffective as the next:

  1. Stop prices from rising through (insert re-packaged nonsense policy here)

The real answer is more property tax and to build through all cycles funded by property tax but this is, as they say in Spain ‘cago en el leche’ to everybody when suggested.

Where does that leave us? With as few answers as we started with sadly.

You can’t really stop money from going where it goes, but at least we can be more sincere about some of the momentum behind what is driving property prices crazy and how governments and Central Banks are front and center within that dynamic.

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