A sinking feeling
It was an interesting time leading into the Global Financial Crises (GFC). There were some clear instances where things just didn’t make sense. Property stocks (the REITs, or real estate investment trusts) were a case in point.
The property sector pre-GFC
In the lead up to the GFC, we had significant concerns about the REIT sector. Specifically, we identified risks regarding property valuations and cap rates (a cap, or capitalisation rate, is the rate of return a property makes, based on the rental income it generates) where we thought that these had been pushed too low, including because of the influence of comparative valuations. Additionally, and perhaps even more significantly, gearing levels in very many REITs were unsustainable – debt had to be reduced.
We couldn’t quantify the degree or the timing on how those risks might play out, but there were clear risks there. As a result, we took action to reduce property exposure leading into the GFC (which benefited clients meaningfully afterwards, by greatly reducing capital losses and providing significant index outperformance).
Obvious to many
But it wasn’t just us who were thinking these thoughts. Even mainstream media such as the AFR started publishing articles concerning commercial (i.e. office, retail and industrial) cap rates and risk to valuations. The concerns were fairly commonly held, certainly in the professional investing world.
But property securities prices kept on their merry way. In the year before the GFC peak, to 31-Oct-07, the A-REIT All Ordinaries (XPJAI) increased 18.4%. And this was after the preceding year’s return (to 31-Oct-06) of +29.1% (!). These are very strong performance figures for a sector that should provide quite conservative returns (i.e. it is meant to be lower risk).
It was ugly, to say the least. The property sector significantly underperformed even the significant falls on the general market.
Source: IRESS, First Samuel
But it should be noted we didn’t have a crystal ball – we didn’t foresee the impact on individual REITs, and we didn’t foresee the overall extent of the fall that eventuated or the timing of it. What we did foresee was there was a risk.
Any parallels to today?
We see risk in the residential property sector today. And (again) it isn’t just us – pick up any of the mainstream papers and there is a plethora of articles and commentary regarding risks that exist. These could have a meaningful impact on mortgage impairment level and perhaps on residential property valuations. This would, in turn, feed through to the big-4 banks.
There has been some pressure on their share prices, but they have proven quite resilient – bouncing back readily from pressure (seems to be more so in the weeks when the Royal Commission hearings aren’t on!).
And this is where we see potential parallels with the REIT sector pre-GFC. We don’t know how risks will materialise, which banks will be impacted and the degree, timing etc. But to us, it doesn’t make sense that the banks' share prices are holding up to the degree they are (still well over book value, CBA 2.0x book at 30-Jun-17, and ANZ, NAB and WBC at 1.4x, 1.4x and 1.6x respectively of book at 30-Sep-17 source: IRESS, First Samuel).
It is not unusual to see issues arising in the market six or 12 months in advance. Yet those issues seem to be ignored and the market continues on its merry way.
We could be quite wrong and eating humble pie in a years' time, but we have a similar feeling now re the big-4 banks, as we did re the REITs leading into the GFC.
The other question you should probably ask is what happens if your Investment Team is wrong? We have developed a portfolio that is expected to provide continued strong wealth generation over our 3 year investment horizon – so that your wealth shouldn’t be impacted by us being wrong. But we are attempting to lessen your downside risk if we are right!