How to prepare for a downward valuation cycle

Price matters if your mission is to maximize economic returns over a long investing horizon, writes Bill Schwab, principal at Real Estate Investments.

Real estate valuations fluctuate as supply and demand fluctuates or when there is a rolling adjustment of asset prices as they move to reflect underlying values after a period of over or undervaluation. So key questions for investors are: how long and how much will values fluctuate, and what should be done about it?

The current extended value up cycle has allowed time for market imbalances to develop. Asset pricing is historically elevated in terms of prices, risk premia and return expectations. And the global economy appears to be shifting into a slower growth mode of low inflation and low demand. These factors increase the probability of a valuation downturn as property take-up weakens and prices are reassessed. Assuming the probability of a down cycle is relatively high, but not certain, investors may want to shape portfolios in line with their views on the probability of different investment scenarios being realized. Large investors with low investing constraints – strong balance sheet and cashflow, adequate liquidity reserves, long duration investment horizon, seek to maximize total economic returns over a real estate cycle or longer.

They can allocate their portfolio so that some portion is defensive to reflect a downside scenario, some aggressive to reflect an upside scenario and some to reflect the base case. The percentages of a portfolio dedicated to each position will vary depending on an investor’s view of the probability of the different scenarios, and the impact of each scenario on them.

Allocation strategies

Let’s assume an investor chooses to allocate to their investment scenarios as 30 percent downside, 55 percent base and 15 percent upside. Risk dimensions for selecting the investments include: price sensitivity; liquidity, optionality and control-governance; targeted absolute return levels. The portfolio recommendations can inform an investor where to look for opportunities. Pricing informs the investor which investment to buy or sell. Basis investing is key as overpaying for high or low price sensitivity or optionality characteristics will result in poor return performance. Conversely, buying these attributes cheap should be well rewarded over a valuation cycle. This analysis could translate to the recommendations in the panel.

And let’s remember that allocation strategy informs an investor where to look for opportunities, but price and price sensitivity should inform them what to buy from among those opportunities.