Antifragile
There are times when ingesting a poisonous substance, in small doses, makes you actually better off overall. Hormesis, a pharmacological term, is when exposure to a small dose of a harmful substance actually benefits the organism, acting as a medicine. Similarly, there is even a behavioural concept of ‘post traumatic growth’, where one is strengthened after vanquishing post-traumatic stress. The general thesis as captured by Nassim Nicholas Taleb in his book Antifragile, is a little stress to the system makes the system a lot stronger.
In recent months the system has been buffeted by a lot of stress as a rise in interest rates and inflation has collided with a mammoth debt pile. In the third quarter of 2022, total global debt reached $290 trillion, just shy of the record high of $306 trillion set in the first quarter. PGIM warn that the risks from this soaring debt have risen as central banks have ratcheted up interest rates to quell inflation. Although they concede that it is hard to anticipate where a financial crisis emerges from, they warn that the shift in this leverage to non-bank financial institutions – an unintended consequence of measures taken after the last financial crisis – has left the global economy more vulnerable. In 2000, non-banks held $51 trillion of financial assets, compared with banks’ $58 trillion, according to the Financial Stability Board. Its latest data shows that non-banks held $227 trillion in financial assets at the end of 2020 – far greater than banks at $180 trillion.
Rising interest rates have also reportedly reduced investor appetite for real estate. Almost a quarter of investors interviewed in a survey of the fund associations ANREV, INREV and PREA plan to decrease their allocation to real estate this year. European investors are the most cautious, with 37% of them planning to decrease allocation by 2024. The European fund association INREV observes that North Americans currently are ‘taking a break’ from European real estate. “What U.S. investors typically look for in Europe is higher returns, and that is difficult to achieve in the absence of leverage,” said Iryina Pylupchuk, INREV’s director of market information. On the other hand, Asia Pacific investors targeting Europe reported a substantial increase in preference for opportunistic strategies. “Perhaps they are looking to increase their European portfolios at a discount,” Pylypchuk said.
However, according to the annual Institutional Real Estate Allocations Monitor published by Hodes Weill & Associates and Cornell University’s Baker Program in Real Estate, institutions are actually preparing to lift targets by another 30 basis points to 11.1% in 2023. Target allocations have been on a steady upward trend since 2013 when targets were at 8.9%. “What’s interesting over the past few weeks is that we’ve seen a number of institutions announce that they’re raising their targets further in the face of the opportunity to maybe take advantage of some distress,” said Douglas Weill, Managing Partner at Hodes Weill & Associates. Ohio PERS just announced that they would up their real estate allocation to 12%, and yet another large Pension fund told ConduitRE recently, that it had allocated 15% to real estate (from 10%), an astronomical amount considering the amount of capital they manage.
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Private capital may also target real estate. Knight Frank surveyed more than 600 private bankers, wealth advisors, intermediaries and family offices who between them manage over US$3.5 trillion of wealth for ultra-high net worth clients (UHNWI) and found that for 46% of the survey respondents, real estate was the top investment opportunity, whether “for its attributes as an inflation hedge or due to the benefits of diversification,” Flora Harley, partner, residential research at Knight Frank, said in the report. “Many highlighted the opportunity to secure enhanced return profiles a key advantage. Plus, when investing directly, real estate enables greater control and value-add opportunities.”
Nuveen look ahead at factors shaping private credit and determined we are in an ‘age of scarcity’. With interest rates rising, public credit issuance has stalled and private credit is attracting larger and higher quality financings. Direct lenders have built up record levels of dry powder over recent years but with looming cyclical risks, private lenders are even more selective about the opportunities they take on. In such a time of scarcity, managers with a full suite of private capital solutions and deep sponsor relationships in defensive sectors will rise to the top of preferred lender lists. This is important given Savills estimates the size of the funding gap at around ￡25bn over the next five years which will need to be filled by equity or non-bank debt. Similarly, In Europe, they expect the German and French markets will require €6.2bn and €5.1bn respectively, per annum between 2023-25.
For European property investors, Nuveen (in a separate note) go as far as predicting that 2023 will be ‘golden vintage’, which, in part, is actually due to the challenging period ahead. With re-financings facing negative leverage across almost all sectors, and some unrealistic business plans unravelling, sellers may be driven to market at higher yields than previously available and ultimately lead to further outward yield shift across all sectors. They expect this window of relatively high yields however to be short. Demographic challenges are expected to anchor economies at relatively low rates of growth and interest rate. Occupier markets are not expected though to head to a permanent collapse, due to record low unemployment, an investment boom in new energy and widespread adoption of new technologies. Property is therefore likely come back into favour after the market reset.
Credit Suisse (as reported in React News) are similarly optimistic about the prospects for real estate. They expect to see rental growth in multiple markets where supply-demand imbalances persist. This rental growth will lend support to capital values, including selected prime offices, multifamily, and logistics assets in particular. Their suggestions include selling nonperforming assets and assets with weak long-term fundamentals, allocating the capital into long-term growing sectors and regions. For value-add investors, it becomes essential to manage assets up to a high level of energy efficiency, focusing on up-to-date insulation, better heating, ventilation, and on-site energy production, for example. Value-add investors must be ready to deploy capital. The short-term cycle is working against existing value-add investors, but as values trend downward in 2023, the trough gets closer in time. Judging from history, 2023 looks like it will be an interesting vintage year for value-add investments.
Taleb writes: ‘Wind extinguishes a candle and energises fire. Likewise with randomness, certainty and chaos: you want to use them, not hide from them. You want to be the fire and wish for the wind. This is the response to uncertainty.’ The stresses in the financial system - whether its inflation, rising rates or unremitting debt - is undoubtedly recalibrating the system, but the response is resounding; with more capital, not less, targeting the sector.?