Covid-19 has put our financial markets into disarray. So how can committed real estate investors decide which sectors to invest into and when?
To invest profitably, investors need to have a sense of the timing of reversion from disrupted asset prices to equilibrium values for the various real estate sectors. Equilibrium value is the value toward which market prices trend as the market comes into long-term balance.
One view on this reversion is as indicated in the accompanying chart, which plots price semi-variance – volatility to increasing prices – against time. This information can be applied to understand the relative value of investments at a point in time in order to buy cheap and sell expensive. It can also be used to project how price evolves over a cycle in order to understand how cheap is cheap and how expensive is expensive.
So, what is my company’s relative value investment perspective and how do we implement it? Our perspective is derived from a liquidity-preference framework. And the return of normal liquidity preferences to financial markets in severe distress is usually driven by government support. Governments support markets when:
- There is a cascade of de-leveraging and collapsing prices for financial assets
- When that threatens to de-capitalize corporates, consumers and local governments through declining asset values such that they would be incapable of generating adequate aggregate demand to restart the economy
- Financial asset prices are below the government’s view of long-term sustainable value, implying that government support through asset purchases at distressed prices or the backstopping of credit instruments will be repaid in full as markets stabilize
- Government credit and monetary creation are adequate to support the government purchase of, or credit backstopping for, financial assets
- The financial collapse is unacceptably impacting the real economy.
While the covid-19 experience is one where the real economy has impacted the financial markets first, the markets then went into a loop of value destruction that required government support to reverse. This happened once the above conditions were met, before that loop created even more problems for the reopening of the real economy.
The return to equilibrium
Typically, asset pricing for arcane, untransparent and more illiquid sectors is disrupted first and most severely. This leaves investors holding assets with high mark-to-market equity losses. To raise capital to sustain positions, investors do not sell assets with heavy losses mark-to-market as that would lock in losses. Instead, investors sell more liquid assets which either trade at a premium, like bonds, or smaller discounts, as with structured products. This causes the pricing of liquid assets to come under pressure. Government support can then become necessary as pricing corrections loop through financial markets reinforcing downward pricing trends across multiple sectors, as was the case recently. Although most financial disruptions run from illiquid to liquid assets, price increases off a bottom should run in the opposite direction, liquid to illiquid. This is because liquid markets are most readily and inexpensively supported by government programs.
In a typical financial market recovery, risk in asset sectors will be assessed by market players from lowest to highest and trading will pick up and investment prices tend to stabilize in that order. The accompanying chart illustrates this conceptual principle: equilibrium pricing returns first to highly transparent diversified, senior positions – assets backed by conservative first mortgages on prime properties – with a high degree of transparency in well-regulated markets with historically deep liquidity; and equilibrium pricing returns last to in-transparent private markets, including historically volatile emerging markets, which tend to stabilize as investors reach for returns by moving out of the transparent liquid asset classes into more illiquid ones – so that investors do much of the work for governments in stabilizing these illiquid markets.
There is money to be made as disrupted markets settle down under government support with the answer to our question being: ‘invest into whatever it is that the government wants you to invest into, as they will incentivize you to do so and support markets to achieve it’; follow the government support programs.
Governments in the past and during the present want to sequentially stabilize risk pricing from highly transparent liquid markets to illiquid ones as this is the fastest, least costly approach to calming disrupted capital markets.