The Gap in Prime-‐Secondary Real Estate
Total Returns:
Its Determinants,
and the Implications for Investors
in Anticipation of the Economic
Recovery
Thesis
by
Mircea Tascau
10390979
Master’s of Business Economics: Real Estate Finance
20
thof January, 2014
First Coordinator: Dr. Marcel Theebe
Second Coordinator: Dr. Razvan Vlahu
Table of Contents
1.
Introduction………....3
2.
Literature Review and Overview of Variables………...5
2.1
Prime-‐Secondary Gap in Total Returns……….6
2.2
Independent Variables in More Detail………13
2.2.1
Recession………..13
2.2.2
Risk Aversion……….18
2.2.3
Credit Availability………...21
3.
Research Design………26
3.1
Hypotheses………..26
3.2
Data………..28
3.3
Methodology………...31
4.
Results……….36
4.1
Main Results………36
4.2
Interpretation of Results……….41
5.
Conclusion……….46
References………..47
Appendix……….50
1. Introduction
In the current post crisis period, a noticeable and nevertheless rational trend took shape with respect to the investment activity within all asset classes. More specifically, investors, both domestic and international, display a vehement preference for prime assets, and an exacerbated aversion towards risk. The subprime crisis that started in the United States quickly contaminated the international markets affecting even the most diversified stockholders.
The scale and severity of this crisis pushed researchers to raise a highly relevant question pertaining to whether or not financial crises that prevail in different markets and at different points in time are fundamentally alike. A recent study by Dungey et al. (2010) looked at five of the most prominent recessions of the decade prior to 2008. While the common educated guess is based of the fact that crises are triggered by different circumstances, and thus implies that they must be different, the findings of these authors suggest that financial crises are in fact very much alike. Their model proposes three channels of contagion, and the empirical evidence suggests that all three transmission channels were common across all five recessions and thus implies that indeed financial crises are alike. However the significance of these channels varies relatively among crises.
In a different line of thought, existent studies suggest an optimistic outlook for the near future. While in 2013, the gap between prime and secondary properties’ performance is expected to continue to grow, by 2014 this situation will reverse and the secondary property total returns and capital growth are expected to match, and then surpass their prime equivalents. As returns and risk aversion are highly correlated, this scenario implies that investors’ confidence in the market is healing, which in turn may be an indication of a foreseeable recovery. However, risk aversion is not the only driver of the secondary market’s weakness. Two more are believed to be significant, and these are the ongoing recession itself, and the scarcity of credit.
Considering the novelty and relevance of these articles, this thesis proposes an analysis that is modeled based on both of the above-‐mentioned studies in an attempt to answer the following question: Do the degree of risk aversion, the severity
of the recession, and the availability of credit differ relatively among continents, or do they all play equivalent roles in the primary and secondary real estate markets’ relative performance, regardless of the geographical location? Answering this
question would implicitly touch upon other highly related issues. Are some investors more risk averse than others? Are bank’s conditions relatively more lax in different parts of the world? Are some markets more sensitive to economic downturns than others? The results will be discussed in light of the prime-‐ secondary property performance within three pre-‐established geographical locations.
Analyzing these relationships would ideally provide an extra degree of certainty in the computation of the expected risk and return profile. This would certainly facilitate investors’ decision making with regards to allocation among different markets. It would make the allocation process more systematic by allowing investors to make an educated, rational choice between investing in a well diversified portfolio that includes both prime and secondary properties, or sticking to the more conservative choice of holding prime real estate assets until subsequent opportunities arise.
For the purpose of this study, the total returns of various publicly traded companies’ real estate portfolios will constitute the main variable. The data set spans from 2005 to 2013, and covers the property markets of New York and California, London, and Hong Kong. Currently among the world’s largest financial centers, these are believed, on the one hand, to be best representative for their respective continents, and on the other hand, and maybe more importantly, to give a sense of how significant geographical diversification is and how it could adjust for different investor criteria such as risk or capital. Companies will be sorted according to their calculated cap rates and allocated to two distinct indices for each market, such that the companies with the highest cap rates would serve as proxies for secondary properties, while the real estate companies with the lowest cap rates would substitute for primary properties. The cap rates are calculated out of data available from SNL.
The contents of this thesis are presented in the following order. Subsequent to the introduction is the literary review presenting the relevant findings in the existing literature. Then, hypotheses are formed based on the research. Next is a section that explains in more detail the data and the manipulation process, followed by the description of the methodology. The fourth chapter describes and interprets the results, and the fifth chapter concludes.
2. Literature Review and Overview of Variables
This thesis is inspired by a study that has been performed first by CBRE Global Investors in February 2011, and which has been focused solely on the property market of the United States. Subsequently the same study was replicated in January 2013 by DTZ for the United Kingdom. Unfortunately, no such report was found for Hong Kong. The aim of both researches was to justify their prediction for each respective market. According to these projections, secondary properties would eventually outperform their primary counterparts, thus reversing the current situation to reflect the normal risk return profile according to which additional risk is compensated by higher return. The current situation as described by the authors is one in which prime properties yield higher returns than secondary. This apparent abnormality is justified by the flight to safety on behalf of investors and renters, which makes it such that
the owners of prime
properties are
compensated with a higher return not because of the risk they undertake, but because of the scarcity of and high demand for such locations. What is more interesting is that, even though these studies are performed by separate companies on different continents, and years apart, they come to the
same conclusion which anticipates the return to normality and the stabilization of both prime and secondary rates in 2014. Also common to both analyses is the finding that indicates the presence of a substantial divide between the markets of the main financial centers and those of the rest of the country. However, the authors disagree upon which independent variable bares more significance, and after a close re-‐examination of the articles, this disagreement does not seem to have to do with the geographical location nor with the state of the economy of the respective markets. According to CBRE, debt availability is by far the most important variable that dictates the direction and scale of price movements, whereas DTZ perceives the recession and implicitly the highly correlated level of risk aversion as being the dominant factors. A more in-‐depth look at each of these studies is likely to facilitate the understanding of the motivation behind the research question underlying this thesis.
2.1 Prime-‐Secondary Gap in Total Returns
The purpose of this section is to expose the reader to previous studies that looked into the determinants of the prime-‐secondary property performance gap. Single market studies were found for the UK and for the United States. These will be discussed first. Subsequently, the prime-‐secondary total return differential will be looked at from a time-‐varying perspective. The section ends with a quick review of additional studies that highlight the importance of the research question and provide additional information, which helps towards formulating a hypothesis.
CBRE Global Investors -‐ Research Department Time to Focus on “Next-‐Tier” U.S. Markets
Written in 2011, this market analysis went against the so-‐called conventional wisdom that prevailed at that time and suggested that the price divergence between the prime and secondary market would continue to widen for another three years. This expectation was attributed to the fact that risk-‐free rates were still low and credit was available almost exclusively to the potential buyers of the scarce stabilized assets. Thus, the research question justifiably revolved around the issue of which of the secondary markets would move up in rank and become the next-‐tier prime markets. Obviously, a straightforward answer could not have been a likely outcome of this study. However, analyzing the factors that determine the performance of the previously mentioned markets would certainly facilitate projections and increase their probabilities. For simplicity and for the purpose of this thesis, from now on these factors will be referred to as recession, risk aversion, and credit availability. Naturally, the terms used in different studies vary, but their definitions remain constant. Therefore, according to CBRE Global Investors, the situation in the US market in 2011 was as follows.
The recession accounted for 15% of the drop in rents since 2008, and when adjusting for vacancy, this drop amounted to roughly 20%. Even though this is a considerable percentage, the significance of income streams fades in comparison to the influence on price that is exercised by changes in discount rates. But this will be addressed shortly.
Highly related to recession is the investors’ risk aversion. The effect of the upsurge of this factor was a freeze on the market, which thrashed any remaining trace of liquidity, especially in the secondary markets, but not only. However, the situation was nonetheless mellowed by the persisting low risk free rates, which exercised a cap effect on capitalization rates by maintaining the fixed income yields low, and thus less attractive to the newly-‐turned-‐extra-‐cautious investor.
The availability of credit, arguably the most significant of the three factors, was already introduced alongside the previous ones. Considered by many to be the cause of the real estate boom, it most definitely was highly responsible for the amplitude of the burst. CBRE estimated that debt alone caused 45%, if not more, of the devaluation of commercial real estate in the United States. Not only this, but also more importantly, the recovery is believed to be reliant on credit availability more than on any other factor. While loans are widely available for prime properties, banks’ reluctance to fund secondary real estate lead to a widening pricing gap between these property types. After a period of almost homogenous real estate values, the crisis rendered prices heterogeneous to the point where in most Metropolitan Statistical Areas (MSA) the notion of market price became inapplicable. Still, even in this respect prime properties are more stabilized most likely due to higher liquidity generated by the availability of lower interest rates at better terms, and higher LTVs.
The study concludes by portraying a slow but gradual recovery from the recession, during which the most interesting opportunities will be presented not by the top tier real estate, but by the next-‐tier which is defined as secondary properties that have the potential to turn into prime locations in the event in which their rent cycles would begin to fluctuate less and their cap rates would decrease and become more stable.
DTZ Insight
Secondary to outperform prime from 2014
According to DTZ, the situation in the United Kingdom is not too different from that described in the CBRE US report. Pre-‐crisis, there has been a long and persistent correlation between the prime and secondary markets in the UK. In fact it was so close that practitioners used the more transparent prime properties to deduct cap rates for the secondary market. However, currently, the same as in the United States, the secondary market’s growth is still to recover after a 17% drop in rents, while prime properties outperformed for the past three years, growing at a 3.3% rate. The good news is that by 2014, the return gap between secondary and prime properties is expected to become positive and stabilize. Interestingly nonetheless, the authors from DTZ attribute this convalescence to higher expected income return rather than to changes in discount rates. More income would rejuvenate investors’ risk appetite, and would implicitly push them more towards the secondary property class. The same three economic factors were analyzed, but the outcome differs from that of CBRE’s report. According to DTZ, the recession seems to be the determinant factor.
The high correlation between GDP growth and capital value growth indicates that periods of recession bring about periods of positive prime-‐ secondary gaps, while when the economy is performing well, the secondary market performs better than the prime. The same as in the previous study, the recovery in prime property values is at least partially assigned to the limited supply, while this is not the case for the buyer’s
market of widely available secondary
real estate.
Although no correlation coefficient is presented, investors’ risk aversion is assumed to go hand-‐in-‐hand with the recession. This is evident not only from the peak in the BBB spreads in 2009 and 2011, but also from the symetrical performance of the GDP growth and that of the risky assets, depicted in the adjacent graphs. This abnormally high compensation demanded by investors in order to accept higher risk is polarizing the real estate market as, on the one hand,
it causes prices of secondary properties to drop significantly, while on
the other hand, increased demand for prime, coupled with limited supply of stabilized properties considerably increases the value of high quality properties.
When it comes to credit availability, DTZ measured the cumulative volume of UK loan
sales and discount to face value. The empirical results corresponded to a recent
increase in discounts to an estimated 50-‐60%. This phenomenon is highly indicative of banks’ strategy to decrease their exposure to secondary assets. In turn, this also means that less credit is and will be available, at least in the short run, to secondary real estate investors. So their prediction according to which the gap between the prime and secondary values will continue to widen before 2014 when it would eventually shrink and then stabilize is indeed supported by these results.
While, according to DTZ, recession remains the main determinant factor, the authors acknowledge a high correlation between yield spread and risk aversion as well. Again, this can be observed from graphs, but in fact no actual correlation coefficient is presented. However, the conclusion of the report is quite clear as it forecasts that secondary real estate will outperform primary by 2014, and that, also
Figure 2
Figure 3
by then, the capital values of both types of properties will stabilize. Thus, DTZ’s inferences for the UK market coincide with those of CBRE for the United States. However they disagree with respect to which variable is determinant. As either one could be the cause, depending on the viewpoint, a regression analysis may shed some light upon this technicality.
Prime versus secondary real estate: when to buy and sell
The only academic study that comes close to the research question of this thesis is titled “Prime versus secondary real estate: when to buy and sell” by Lim, Berry and Sieraki (2012). The purpose of this article is to use the gap between prime and secondary property yields as an indicative instrument regarding the optimal portfolio allocation. Their quantitative cross sectional analysis helps observing the quarterly evolution of the prime-‐secondary total return differential over the period 2001-‐2011 according to which investors’ buy/sell decision can be influenced, based on the calculated risk that each of them is willing to take individually. The study is limited to the UK market, and focuses primarily on the greater London area.
When putting the three articles in perspective, this study seems to be more in agreement with the CBRE report, rather than with DTZ’s, in the sense that, according to its findings, the return is more influenced by capital growth rather than by income return, which suggests, although not implying with certitude, that the discount rate might be more significant. However, by pointing out that the scarcity of prime properties forces investors to consider placing their capital in the slightly riskier secondary real estate, it is indirectly implying a shrinkage in the yield gap between these asset categories in the near future, which is consistent with both CBRE’s and DTZ’s visions. Additionally, this article validates CBRE’s expectations with regards to potential arbitrage opportunities associated with the likelihood of the emergence of the so-‐called next tier properties. Nevertheless, the most interesting, and at the same time the most intriguing finding of this academic article is that market timing is supposedly the most determinant factor for returns, as it is directly responsible for the scale of capital growth. Of course market timing coincides with the state of the economy, which indeed is the previously introduced variable, namely recession.
Thus, after reviewing the limited existing literature pertaining to the prime-‐ secondary yield gap, the only professional and academic articles that were found seem to unanimously agree with respect to their economic predictions as well as regarding the time frame. Conversely, when it comes to the relative significance of the independent variables, results and opinions are various. This however, makes for precisely the research question of this thesis. Moreover, all three studies sustain the purpose of this thesis by consistently agreeing upon the fact that adding secondary property to the portfolio has the potential to create risk-‐adjusted value.
Review of Additional Studies
Additional studies that relate to the topic of this thesis were found. Even though they do not necessarily come as close to the subject as the three articles reviewed above, they confirm this thesis’s position with respect to the performance of the prime and secondary properties, and they each bring complementary information pertaining to both the independent and dependent variables.
A very interesting study comes again from CBRE (2012). Their Global Vision opens with a thought-‐provoking statement about Australia, whose real estate is expected to keep performing strongly for the years to come. However it seems to be highly recommended that global investors don’t limit themselves to similar safe haven markets as both good performers and underperformers are bound to experience a change of course at some point in time or another. Hence the gap between prime and secondary property yields is expected to close, however not before credit becomes more abundant. According to this report, prime properties, which are defined as the assets with the
most transparent and predictable income streams, continue to be the most scarce and liquid on the market, and thus still the most sought for by investors. In spite of a 41% decrease in prime property yields since 2010, compared to the 19% improvement in secondary prices, real estate continues to be the preferred alternative to fixed income. The attached graph helps providing a sense of scale.
AVIVA (2012) concurs with CBRE’s and DTZ’s expectations and agrees with Lim, Berry and Sieraki (2012) on the importance of market timing. Briefly, AVIVA too observed a widening of the prime-‐secondary yield gap in the UK market since 2009, and they anticipate the gap to close as we approach 2014. They attribute the current price differential mainly to the recession and to investors’ risk aversion. However, the
availability of credit is not taken under consideration. In their view, the economic
recovery and the revitalization of risk appetite would bring about a substantial increase in secondary property prices. That is why investors seeking cyclical opportunities are advised to act immediately as the trough of secondary values would obviously optimize the yields of a buy low – sell high strategy. In spite of this optimism, warnings about the performance of both prime and secondary markets are presented. First, the end of the recession would implicitly exercise an upward pressure on government bond yields as investors move up on the risk-‐return curve. In turn, high risk free rates would render prime real estate investment less
Figure 4
attractive relative to fixed income, and thus prices of stabilized properties would drop. Second, as the economy recuperates, banks may try to liquidate many of their underperforming loans and low quality real estate, and this would inhibit the recovery of secondary prices. All things considered, AVIVA suggests that substantial capital gains in the secondary market are nevertheless expected in the coming years.
While AVIVA completely omitted to look into the level of credit availability and the consequences this factor has on the real estate prime and secondary markets, GVA (2011) seems to focus most of its UK market analysis on precisely this variable. The adjacent graph helps the
reader by providing a visual representation of the size of the price gap between prime and secondary British real estate. While high quality properties gained back a quarter of the value they lost since the crisis, lower quality properties, which dropped even lower, recuperated merely 12% of that decline. According to GVA, this is
explained mainly by the very low level of new loans (£20 billion in 2010)
and LTV ratios limited to around 60%. These new loans are almost exclusively available to prime properties, as opposed to outstanding debt, 62% of which was given out pre-‐crisis to buyers of secondary real estate. Not only this, but the LTVs then were much higher also. Moreover, 70% of the existing loans are to be paid back by 2015, while banks are eager to reduce their real estate exposure. This means that a lot of properties, especially those of lower quality, will overwhelm the market and prices will drop further. Even if this 2011 scenario seems far more pessimistic than DTZ’s 2013 UK report, GVA also suggests that, in the long run, substantial capital gains can be made if undervalued secondary real estate is purchased in the near future.
On a more different note, an earlier study by Callender et al. (2007) was found to be highly relevant to this thesis. The article looks at the risk-‐reducing effect of diversification, and the results, which will be discussed shortly, tend to confirm the findings of previous work. However, before moving any further it is imperiously necessary to discuss some theoretical relationships brought up by the authors of this text. First, as it was pointed out in the aftermath of the most recent financial crisis, at the portfolio level, what counts is not necessarily the risk contained by the assets, but rather the covariance between them. At the institutional level, and not only, portfolios are composed of different asset classes in various proportions. Ranging from stocks to bonds and fixed income, to foreign exchange, real estate, etc., the composition of these portfolios is indeed widely diverse. Thus, in absence of
restrictive regulations, finding even riskier but high yielding secondary properties that are weakly correlated with the vast amalgam of assets in place should be feasible regardless of the state of the economy. Second, the relationship among the different types of risk, and the number of assets making up the portfolio is illustrated by means of a simple, straightforward formula:
R
!=
𝑛 ∗ systematic risk
𝑛 ∗ systematic risk + 𝑎𝑠𝑠𝑒𝑡 𝑠𝑝𝑒𝑐𝑖𝑓𝑖𝑐 𝑟𝑖𝑠𝑘
where R2 is the ratio of systematic variance to total variance, and n is the number of
assets. It becomes obvious how, by increasing the number of assets, the proportion of non-‐diversifiable risk for which investors are compensated increases considerably in the composition of total risk. According to the results, it was estimated that good diversification could be achieved by holding anywhere between 30 and 60 properties, whereas almost maximum diversification may be achieved in portfolios composed of 200 properties or more. Thus selling off prime assets in order to use the funds to get exposure to cheaper, more numerous secondary properties would have the effect of increasing risk-‐adjusted returns in sizable portfolios. This observation stands in favour of the hypothesis which suggests that in a recovering economy, it might be appropriate to partially move away from core assets and consider a broader diversification, including perhaps higher yielding, more opportunistic assets. This is not to say that investors should replicate the strategies that lead to the 2008 financial crisis. The pre-‐crisis toxic portfolios were exposed to a much higher correlation between assets than it was believed. However, portfolios including a large enough number of prime and secondary properties are expected to be more closely linked to the market (Byrne and Lee (2003)) and thus follow the evolution of the market index, while being exposed mainly to systematic risk. Of course well-‐managed small portfolios with low asset correlations are also considered to be safe, but their performance is not tied to the market, and while this could be a good countercyclical strategy, in a recovering economy, tracking the market cycle may not be such a bad idea especially when high risk-‐adjusted returns are to be expected.
Summary
This section looked at previous findings pertaining to the prime-‐secondary gap in total returns as a dependent variable. Briefly, the main conclusion is that, among the three determinant factors, there is no predominant independent variable. Credit availability seems to be most significant in the United States. Mainly recession, but also risk aversion due to their high correlation, seems to dominate the size of the UK real estate performance gap. And finally, the more academic, time-‐varying approach appears to also appoint recession as being the most significant explanatory variable for the British market. It seems thus, that different markets are most sensitive to different factors.
2.2 Independent Variables in More Detail
As researchers disagree upon the relative efficiency of the different factors influencing the magnitude of the prime-‐secondary property performance gap, and especially before running the regression analyses that will make the subject of the next chapter, it can only be hypothesized as to which explanatory variable is likely to be the most significant. Thus, this section’s purpose is to examine to a certain extent the more subtle aspects of these determinants. First, recession will be discussed from a cross-‐market perspective. Then, financial crises of the most volatile markets will be addressed as they stand to be the most affected during economic downturns, and finally contagion between financial markets and real estate will also be considered. Second, risk aversion will be dissected into three components, namely: investor sentiment, uncertainty aversion, and risk appetite. Third and last, the analysis of credit availability will tackle such issues as domestic credit and interest rates, lenders’ behaviour, and disintermediation and agency issues.
2.2.1
Recession
During times of economic distress, banks and other financial institutions particularly need to overcome the challenge of fulfilling their role of liquidity providers in order to avoid bank runs and other hostile self-‐fulfilling prophecies. This is evidenced, in part, by the increasingly sophisticated capital adequacy regulations such as the ones imposed or envisaged by the Basel I, II and III accords. As loans tend to be very illiquid, banks cannot afford, and to some extent they are not even legally allowed, to have a large exposure to many additional high-‐risk, illiquid assets such as subprime properties, and thus they prefer prime investments. This translates into less credit available to secondary real estate investors on the one hand, and on the other, a constant level or maybe even more credit available to those who seek financing for prime property investments. This makes safe real estate more liquid and more appealing, while the secondary properties face even further price depreciation and obstruct access to capital as liquidity costs upsurge. These issues will be addressed in more detail in the following sections, but for now this discussion was brought up in order to bring attention upon the important role played by the economic cycle in the relative performance of the prime and secondary real estate performance. The direction of causality between credit availability and recession is not always clear, which is why it is essential to address both concerns carefully. Capital adequacy regulations are in place throughout the market cycle, but in recessionary times more than ever cash is king. As the secondary property market is by far larger than the more exclusive prime sector, during recessionary times the biggest losses materialize in the former market, to which most investors are exposed. This is another reason why it is appropriate to
have a good understanding the downside of the market cycle, as this economic period has a very large effect on the gap between prime and secondary real estate performance, and it is decidedly harmful to most real estate investors’ portfolio performance.
Are Financial Crises Alike?
As it was made quite clear in the previous discussion about the gap in prime and secondary property markets’ performance, that the highest-‐yielding real estate was the segment in which values declined the most during the financial crisis of 2007. That is why a thorough understanding of these economic downturns is necessary for the purposes of investment decisions and portfolio allocation.
An IMF working paper by Dungey et al. (2010) looks into the Russian, the Brazilian, the dot-‐com, the Argentinian and the US subprime crises in order to assess the similarity among them. The data consists of stocks and bonds from the respective countries over the period 1998-‐2007. In the authors’ view, crises are first triggered by one or more shocks and then these shocks are transmitted to other countries and financial markets through contagion. Thus three contagion channels are further discerned. Through the Idiosyncratic channel, a shock that affects a certain asset market of a certain country is transmitted to the same asset market of other countries. The Market channel propagates the shock from one global asset class to all asset classes at the same time. Finally, the Country channel takes a shock that originated in a certain country and spreads it to other countries. The results show that all these three channels have statistical significance, which makes it possible to fit any and all of the given crisis through the same model, meaning that financial crises that differ simultaneously with respect to the nature of the triggering shock, as well as across time and national borders are indeed similar. However, the intensity of the contagion effects varies relatively from one crisis to another. Credit crunches such as the one in Russia in 1998 and the most recent US subprime appear to be the most contagious. During 2007’s Global Financial Crisis, more than 92% of the volatility in the US bond market was assigned to contagion effects. These effects were spread worldwide with the exception of no country and, more severely, all of the three channels operated in the same proportion.
Perhaps the most important implication of this finding that suggests the similarity of international financial crises is that it offers the proactive investor a certain advantage in foreseeing economic turmoil and in avoiding markets that stand to be affected in the near future. It means that international investors can invest in secondary markets with more confidence, to the extent to which they are able to recognize and identify alarming events. It is easy to see how this strategy would increase the demand for the less stable assets while shrinking the size of the prime-‐ secondary property performance gap.
Are All Emerging Market Crises Alike?
While the main financial centers of the world, widely viewed as safe heavens, are subdivided into prime and secondary markets with respect to real estate, the recent literature regards the emerging economies as being mainly large secondary markets with certain areas relatively less risky than the others, but not to the extent to which they would be worth of being labelled prime. Thus, as emerging market economies (EME) are often confounded with secondary real estate markets, the evolution of EMEs through times of financial and economic distress becomes relevant for the purpose of this thesis. Again, the reason for this is that the biggest losses are highly likely to be brought in by unstable assets or by volatile markets. This would implicitly have an enlarging effect on the performance gap between prime and secondary real estate.
Another IMF paper written by Chamon, Ghosh, and Kim (2010) targets precisely the nature of crises in the EMEs. In their view, the corollaries of these crises appear to be similar. A sharp decrease in output, the collapse of the exchange rate and a current account deficit make up the norm. However, the causes of such events are seemingly rather heterogeneous. A distinction is made between underlying
vulnerabilities and triggers. The former are generally maturity-‐, currency-‐, capital-‐
mismatches, or a combination thereof. Together, they are referred to as balance sheet mismatches which are easily identifiable. The latter, are more diverse and unpredictable events of political or economical nature, either endogenous or exogenous to the respective national economy. The triggering events, however, are less important given their unpredictable nature. Thus, the attention should be focused on the more preventable weaknesses. Once any vulnerability is eradicated, the likelihood of the occurrence of a crisis is eliminated, as any eventual trigger would have nothing to exacerbate. From the viewpoint of real estate investors, once these vulnerabilities are taken into concern and proper compensation is demanded for the underlying risk, their exposure to hazard is secured and their decision to invest becomes fully rational. However, it is usually the case that problems arising in one economic sector, if persistent, end up spreading, usually through the banking system, into other sectors, and eventually escalate into vulnerabilities. Early signs can nevertheless be seen in weak domestic balance sheets, low foreign exchange reserves, or high debt-‐to-‐equity ratios, among others. It goes without saying that investors’ familiarity with the market and with the underlying economy is an essential prerequisite for any good investment decision. As a general rule of thumb, if the GDP or alternatively the net private capital flow has fallen by 3% from the preceding year and this coincides with a 2% drop relative to the year before that, the respective economy is considered to be showing signs of vulnerability. Additionally, the debt-‐export ratio and an overvaluation of the real exchange rate are the main external indicators of vulnerability. The results of the statistical analyses undertaken as part of this study indicate that a 1.82% decrease in real GDP growth suggests a 1% increase in vulnerability or crisis predisposition. The inverse
relationship becomes true once a crisis has emerged, resulting in reduced productivity, which generates a vicious cycle that eventually would grow to include other implicated economies as well. To visually illustrate the relationship and correlation between gross domestic product and the
estimated crisis vulnerability, the following
graphical representation was attached. More specifically, the EMEs’ average vulnerability just prior to 2007 was estimated at 5.2%, while the worst positioned country had an 8.8% probability to end up in a recession. Moreover, highly related to the discussion in the previous section are the suggested consequences of the substantial and homogenous, withdrawals of funds from EMEs on behalf of banks of the developed countries. This has lead to an upsurge in risk aversion and a decrease in productivity, which further increased the default probability of these developing countries. The study concludes that the pre-‐existent vulnerabilities of the
emerging markets indeed dictated their evolution throughout this financial crisis.
Transnational investors’ awareness of these signals and vulnerabilities facilitates and insures their decision-‐making process by providing them with grounds for international comparison, as well as by giving out red signals before illiquidity sets in. More specifically, such information would have the effect of decreasing the performance gap between prime and secondary realty by reducing the risk exposure and by maintaining adequate demand for higher yielding properties. The mechanics of such a strategy would resemble those of a floor option on stocks.
Contagion Channels between Real Estate and Financial Markets
As an article by Chun, Sa-‐Aadu and Shilling (2004) indicates, institutional investors should invest up to 12% of their assets in real estate in order to eliminate non-‐ systematic risk. Conversely, rational real estate investors would hold diversified portfolios that additionally include various other asset classes. Thus, the discussion about the current economic environment would not be complete without diving into the relationship between real estate and other financial markets.
Hoesli and Reka (2013) explore the factors that lead to contagion between the US property market and other financial markets. Consistently with the other articles
Figure 6
discussed, contagion continues to be described as the “correlations over and above what might be expected by economic fundamentals” (Bekaert, Harvey and Ng (2005)). Interestingly, according to Hoesli and Reka, their study is the first to tackle contagion in the field of real estate. Out of the four factors considered, only liquidity
correlation and the behavioural dimension, which includes investors’ sentiment and
panic risk, seem to be significant. Information correlation, or the ability of uninformed but rational agents to extract information from changes in price that occur in remote markets, appears to be irrelevant. And so does the portfolio
rebalancing factor. The latter is a strategy according to which portfolios are divested
from those assets that performed poorly in other markets. The liquidity correlation factor originates from a decreased availability of credit or a drop in asset values, which dilutes investment as it becomes increasingly more difficult for investors to obtain capital. Not surprisingly, this coincides with the events that onset the most recent financial crisis. Funding liquidity and market liquidity are said to form a liquidity spiral as they viciously feed upon each other. The other significant factor, namely the behaviour dimension, goes hand in hand with the herding effect, which is nothing other than highly correlated activities among traders generated by increased risk aversion such as seen in flight-‐to-‐safety decisions. When this behaviour is induced by so-‐called irrational incentives, it is referred to as investor
sentiment. And recently in the academic literature, the idea that current prices are
based on investor sentiment is quickly gaining terrain as the self-‐fulfilling prophecy accounts for wide oscillations in the degree of market risk. This means that the
relative values, yields and rates of return, implicitly the prime-‐secondary property
performance gap, are also partially sentiment based. However, on the more quantifiable side, as diversification looses efficiency once the herding effect kicks in, credit availability becomes essential in order to restore liquidity and counteract contagion.
Summary
Recession covered the worst-‐case scenario in which secondary properties perform
poorly and in which they are highly exposed, and thus constitute the highest risk. In good economic times, secondary properties yield higher returns than prime and thus are more profitable. The higher risk that they bear is likely to materialize primarily in the event of a crisis. Unforeseen events could, of course, affect the performance of both prime and secondary real estate even when the economy is running well, although this would rather happen in isolation and have lower magnitudes. Because this section focused on the most pessimistic situation, it was possible to identify some loss-‐preventing measures that would be most valuable to the investors who hesitate between investing in prime or in secondary properties. We have seen that financial crises are alike and that a shock to one asset class in a particular country is very likely to be transmitted across asset classes and outside national borders. Moreover, at least for the emerging economies, it was also shown that the degree to which they are affected by crises, and their performance throughout economic downturns are dictated by the extent to which they are
