There is a case to be made that in the next downturn, retail property may perform worse and industrial property better given the structural change occurring in both sectors. But even so, the starting point of expectations for both sectors probably already reflects these issues.
Taking this analysis one step further, we looked at real estate performance when the S&P500 declined more than 1 per cent during 2019. As in 2007 to 2009, lodging, office and industrial all performed poorly while health, student accommodation and storage held up well. On this occasion, though, malls performed poorly, too.
Another aspect that will have a meaningful impact on real estate performance is leverage. There are many ways to measure leverage. The most common is loan-to-value (LVR), although this approach has some significant shortcomings – notably the quality of the V.
Our philosophy on leverage is that it is safer to have an LVR of 50 per cent where value is half replacement cost than an LVR of 30 per cent where values are double replacement cost. In that context, investors should be wary of low LVRs across well-bid sectors such as office and industrial property in the current cycle.
Another leverage measure is net debt to earnings before interest, tax, depreciation and amortisation (EBITDA). In essence, this reflects how many years of pre-depreciation cashflow covers net debt. It measures leverage against the earnings capacity of the underlying assets, rather than the market value of those assets. Again, it’s not a perfect measure but provides a useful guide for investors.
Taking all this into account, our approach is to skew our portfolio to lower risk assets with low leverage within the real estate landscape. That may mean there are times we miss some of the upside, but as long as we protect against the downside while achieving our total return objective through the cycle, that’s a good result. Ultimately, the key to property investing is wealth preservation.
Chris Bedingfield is co-founder of Quay Global Investors