High asset prices and talk of inflation trigger cautious mood

The outbreak of COVID-19 had a cataclysmic impact on the global economy, with the governments of first world countries injecting populations with fiscal stimulus and incentives to keep their respective economies afloat.

While there’s no doubt this support softened the blow of COVID-driven economic instability, particularly in Australia, the resulting deficits will invariably have a longer-term effect of some sort.

With conditions creating potential for inflationary pressures and a high likelihood of interest rate rises on the horizon, investment decisions need to have a view to the evolving risk environment.

There’s no doubt there is opportunity that comes with change, however mitigating the risk elements in the first instance serves for sound equity downside protection.

With the unlisted investment-grade real estate sector being a relatively long-dated and illiquid asset class, our investment viewpoint and risk assessment also needs to be long-dated. (At MP Group we don’t generally invest in REITS, which are the more liquid sector of the real estate markets.)

With one eye on the current deal flow and a heavily priced market, our decision making is getting more conservative.

We are looking at under-priced rented assets that can be acquired below replacement value, with a strong probability of outperformance based on robust property fundamentals.

In our decision making, we see a few factors with the potential to drive future structural shifts to the market.

Debt versus money

Historically, high levels of global liquidity create competition in the market and push the pricing of quality assets upwards — but the compilation of that liquidity deserves a closer look.

The current ratio of debt compared to money is skewed, with a higher ratio of debt than equity if you consider the actual value of equity underpinning the overall capital in the market.

This is as a result of the historically low interest rate environment, as well as the COVID-driven government stimulus, which essentially pumped more liquidity into the market.

The significant debt levels in the market, and the cheap cost of that debt, encourages borrowing and spending.

This dynamic ups the ratio of debt to money without the required output of productivity which would usually come with increased liquidity and spending in the market; this cheap debt in the market has enabled us to consume more than we produce.

The difference is, when liquidity and increased spending come from increased productivity there is no debt to repay.

When the increased liquidity comes from debt, however, that borrowed money has to be repaid and possible interest rate rises need to be factored in to any decision making.

Whilst we are investing in the unlisted real estate sector, which infers exposure to bricks and mortar, the investment value of that bricks and mortar comes from the occupancy levels and underlying supply and demand dynamics from the businesses that are paying the rent.

So whilst the capital structure at the asset level may be sound on acquisition, the timing of the lease expiries needs to be taken into consideration, along with financial modelling that considers market fluctuations in supply and demand dynamics for that particular asset over its proposed investment term — and further — to ensure investment value is maintained, culminating in risk-adjusted outperformance over the long term.

Inflation

Inevitably, with so much money being printed in the form of government fiscal stimulus and COVID support, the printing of that cash creates a longer-term issue.

With a fiscal system that isn’t backed by any underling real value, since the conversion from the Gold Standard to Fiat Currency, the literal value of a dollar is becoming arbitrary.

It’s impossible to print more money, not have the dollar pegged to any underlying value metric, and not have it devalue. A devaluation of the dollar leading to price increases is one way the impact of inflation may be felt.

Further compounding the problem, global supply chains have been damaged as a result of COVID and costs are being pushed higher, an example is how the global semi-conductor shortage has contributed to a shortage of new cars, and the knock-on effect has seen the price of second-hand cars surge too.

We recently purchased new televisions for our home, and the wait time on delivery was a month as a result of these supply chain issues.

One of the challenges to inflation is that there’ll never be an interest rate low enough to compensate for it, which means the price of just about everything will continue to rise in relation to cash, and the buying power of a dollar will keep decreasing.

Recent factors noted above will, in our view, likely expedite inflationary events. This will have subsequent knock-on effects to the macro and granular machinations as to how overall economics pan out, as well as impact investment values.

Increasing value of financial assets

As we have seen in the residential market, for example, the price of quality assets is continuing to rise across the board.

High levels of liquidity and easy access to debt is creating more competition for premium assets, pushing cap rates to sharpen and driving investment returns down.

Anecdotally, this can be seen at a domestic level in the residential sector; a friend of mine purchased a one-bedroom apartment in the Ikon residential apartment complex in the Sydney suburb of Potts Point about 15 years ago for $250,000. She sold it a few years later for $550,000. Today, those same one-bedroom apartments trade for around $2 million.

MP Funds Management co-invested in the acquisition of a 15,500 sqm CBD office tower about three years ago; today its value is around double the original acquisition price.

This means the gap between the haves and have nots will continue to widen, and it will be increasingly difficult for those who have not yet entered investment sectors to get a foothold.

Innovation

We are fortunate to be in an era that drives productivity; technology is innovating at faster levels than ever before.

Unlike historic times, innovation will drive economic recovery and evolution to markets. Keeping an eye on structural changes, and planning for those with informed and conservative foresight will yield consistent and compounded investment results over the longer term.

Social factors

The divide between the haves and have nots, and between the right and the left from a social standpoint, will create issues to be aware of which will impact social order and economies, and will have an impact on various sectors of the market.

The rise of China

As China rises to rival the USA as an economic and political superpower, and China’s increasing power is felt globally, economies will likely shift as a result.

We believe this will be an incremental shift over time, but a shift nonetheless, which is important to be aware of in terms of future impacts at both a global and domestic level, and at an investment or asset level.

Diversifying to protect downside

With the environment only becoming more complex over time, sticking to sound and generally simple investment principals has helped us maintain consistent outperformance over time.

Whilst risks may change over time, ultimately looking for outperformance means having a conservative, detailed and disciplined approach.

Whilst we believe in diversification to protect against downside, we also are clear in our investment mandate, which enables us to play for the long game and achieve superior investment returns.

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