Simon Martin
Chief Investment Strategist & Head of Research, Tristan Capital Partners
The late, great Stephen Sondheim was, perhaps, the greatest figure in 20th century musical theatre. He once said the ‘art is, in itself, an attempt to make order out of chaos’. The greatest operatic composers lived in dramatic times. Puccini composed during the Italian wars of reunification. Mozart & Beethoven lived through the first 2 decades of the industrial revolution and the enlightenment. Wagner’s operas are nothing if not tumultuous. It seems that great works of opera are best suited to uncertain times.
Someone somewhere should therefore be writing an opera based on 2022. Post Covid, a war broke out on Europe’s Eastern border, followed by the most rapid increase in interest rates since the early 1980s and a surge in inflation that is unparalleled in this era of globalisation. At the same time, bonds and stock have been correlated, volatile and performed poorly. The UK’s hard-won reputation for fiscal probity has been dented. Crypto rolled over and seems to be dying dramatically. FAANG bit back. Investors have had to be selective to find safe places to store their capital.
Despite this drama, real estate has had a reasonable year. Although denominator effects have lifted real estate allocations for many and capital flows have slowed, the inherent stability of the asset class, solid operating fundamentals and the index linked nature of leases have combined so that investors have been somewhat protected against the headwinds in other markets.
That said, we cannot assume that real estate is fully insulated from the turmoil of the economic outlook. The operating fundamentals are solid and anchored by low supply risk, but everyone understands that the chill winds of recession are blowing into Europe. Central banks seem likely to keep monetary policy tight, so liquidity and financing will be rationed, and portfolio and risk management skills will come to the fore. With energy efficiency and ESG factors becoming more important to tenants, buildings will have to be properly provisioned to ensure that they can compete in a tougher economic climate and so it seems like that capital intensity will continue to rise and asset management skills will need to be on show. Equally, real estate assets are idiosyncratic and illiquid, so pricing risk is complex, and capital does not always flow evenly and efficiently to where it is needed. This raises the risk that people who need capital quickly to cope with the challenges will not be able to find it.
Not all investors will be prepared for these challenges and so it is almost inevitable that some will find themselves frantically searching for help at the wrong moment in time. Some will choose to sell; some may be pushed into selling by impatient creditors. This will result in opportunity for both debt and equity investors. History tells us that investing during periods when capital is scarce is, by every measure, the most accretive for long run performance. That said capital alone is not enough, investors must also show conviction.
We believe that, in today’s ever evolving market, conviction is ultimately a function of the operating fundamentals – the dynamics of supply and demand. On the demand side there are several long run secular trends boosting the demand for space that can be harnessed by landlords to create upside optionality and reduce the cyclical risk that flows from recession. These secular drivers will be most powerful in the cities with the strongest demographics and where the levels of vacancy are low, particularly in cities where construction activity has been slow to recover from covid induced cost and timing effects. These markets will be the most resilient under stress; they are the markets where indexation is most likely to be accepted by tenants; they are the markets where the upside is strongest into recovery and, consequently they are the markets where yields and capitalisation rates will be least impacted by interest rate volatility and uncertainty.
Mark Twain once went to see Wagner’s, ‘Tristan and Isolde’. “Tristan” is said to have knocked the irony right out of him. He wrote: “I have never seen anything like this before”. Twain clearly had taste! But even if they lack his trademark irony, his words are resonant. These are challenging times, but with challenge comes opportunity. There are ways to navigate the tumult. Twain knew that clear-sighted conviction and trust in your ‘composer’ were essential.