Investment Approach in Uncertain Times14 March 2020
As the world comes to terms with the coronavirus there are differing opinions as to the short and long term implications for our economies and the impacts on the property markets.
Federal Governments around the world are spending billions of dollars to contain and treat the virus as well as to support industry and consumers from the financial impacts in order to maintain a stable economy.
Whilst the mortality rate is reasonably well predicted, it is difficult to predict how far and how fast the virus will spread, how long it will last, what long term impacts could it have on tenant and capital markets, and what influence will Government spending, changing currency markets or inflation have on the overall economy.
It is already evident that people's natural response to the coronavirus is to constrain spending, stock pile necessities and defer travel until signs emerge that the virus is contained.
Clearly once it is over, we will see a return to normal consumer behaviours, however we cannot be certain how long this will be or what condition the market will be in at that point.
How then, do we make investment decisions in such uncertain times ?
The answer to this is – "the same as we usually do".
We need to make objective decisions based on the reasonable and the possible outcomes, both positive and negative. Whether it involves a strategy for an existing asset or for an acquisition or even a disposal, the decision process should not change.
The virus will impact the use of property and the businesses who occupy them, ie retailers, hoteliers, office workers etc. Businesses are likely to be forced to cut expenditure and some cases may not survive at all. Replacement tenants may be harder to find and the prospects of lower rents will ultimately result in lower earnings and lower values.
When making any investment decision I recommend establishing three scenarios for each investment strategy; A Base Case, a Low Case and a High Case.
We target the base case, defend for the low case and hope for the high case.
There may be more than one strategy for each investment decision. For example a decision to acquire a Shopping Centre may need to consider it as a long term investment or as a redevelopment option. Each strategy should then consider the Base, Low and High case scenarios.
In establishing each scenario, we identify the key variables that have the greatest impact on the investment return for that strategy, for example, market rental growth patterns, terminal cap rates, vacancy rates, incentives, cap ex, gearing levels and interest rates etc. Typically variables will move in combination so, it is more likely for example, that vacancy will increase whilst market rents decline and incentives increase.
Each Variable must also have a current market based position from which changes are made.
We then establish a Low Case set of scenarios which assume a variety of negative consequences and then test these over various time periods ie short term, mid term and long term horizons.
In establishing a defence against the Low Case there may be some considerations that can be incorporated, for example, vendor rent guarantees or preferential returns in partnership arrangements. In other cases, there may be no defensive arrangement to the strategy, leading you to also consider an alternative strategy all together.
We then establish the High Case in the same way with variables that move together to produce positive outcomes and again test these scenarios for various time periods ie short term, mid term and long term horizons.
The Base Case is typically a reflection of the outcome from reasonable changes in assumptions that are neither overly conservative or overly optimistic. For example it would reasonable to expect that for a Shopping Centre investment, that under the current circumstances sales turnover will decline, vacancy rates increase and market rents decline. A low case sceranio may see these variables drop significantly, whilst a high case may see a minor or short term decline.
The extent to which you believe these variables may move will be determined by the depth of your market intelligence and due diligence process.
Once you've reviewed 10 to 20 scenarios for each Low, Base and High Case you would settle on one version of each Case and present the Investment Strategy with a Base Case scenario and a range of outcomes which vary from the High Case to the Low Case.
If more than one strategy is being considered, then the same process is applied to each strategy, enabling decision makers to weigh up the risks of each strategy with a better understanding of the upside and downside impacts.
Coronavirus, or not, the process of making investment decisions is complex and requires professional advice, extensive market intelligence, thorough due diligence and people with sufficient capability and experience to understand the potential outcomes and key variables.