Now that the property market has steamed ahead for quite some time, in many cases prices up to pre-2008 crash levels, the pundits are now telling us that everything in the garden is rosy and we shouldn’t be concerned. Talk of good value for money and why prices should continue to rise, any flaws in their reasoning explained away, is, at least in my opinion, rather worrying.
The property market as I’ve said is not one big place, where everything that’s going on generally in the economy necessarily rubs off on the market as a whole, but is divided into sectors (for example, residential, commercial, etc) with each individual sector having its own segments. All markets are driven by buyers and sellers, and prices vary according to demand, supply and availability. (Supply and availability are not quite the same thing: availability is what’s actually available when you want to buy. supply is what’s theoretically available regardless).
The residential property market comprises first-time buyers wanting to get onto the property ladder and existing owners that are already on a rung and wanting to upgrade or downsize depending upon their particular requirements. The owner-occupier segment of the residential property market might be regarded as an example of pyramid-selling, whereby prices at the top end depend upon a steady flow of transactions lower down and especially at the bottom, were it not for a segment of the market that involves a different method of financing. That sector is the cash-buyer and, amongst owner-occupiers, cash purchasers tend either to be found at and around the top end of the market, or at lower levels as a result of downsizing. Otherwise, for the most part, buyers are mortgage-dependent, the size of mortgage varying with the amount of equity.
The owner-occupation residential property market ceased being immune to market forces years ago on the arrival of the buy-to-let investor. Buy-to-let investment was facilitated by smaller building societies spotting a lucrative gap in the lending market for financing investment in residential property as a consequence of changes in the law regarding security of tenure for residential lettings. Over the decades, owner-occupiers have become accustomed to hard done-by as a result of politicians ending tax relief on mortgage interest, borrowing cost of improvements, etc. Unlike the owner-occupier whose borrowing does not nowadays come with tax-relief on loan interest, buy-to-let investors, whether cash buyers or on mortgage, can afford to pay more, either through choice or because the net cost of the mortgage is less. To cut a story, increasing number of tenants, partly caused by stringent lending criteria for owner-occupiers, combined with an explosion in the demand for tenanted property, supply and availability increasing including the development of blocks of flats aimed at investors, and conversion of larger properties and upper parts into flats, and release of land for new building, supported by the authorities calling for the building of thousands of new homes, means that the stability of the residential property market and the potential for prices is more volatile than during the benign dictatorship of owner-occupiers alone.
In the context of residential property market prices, the snag with cash buyers is that they are not beholden to any objective valuation checks, so the prices paid by cash buyers can be in a world of their own. Mortgage-dependent buyers, however, are subject to valuation opinion concerning the forced-sale value of the asset to the lender which can act as a second-opinion curb on excessive lending and prices, pre-supposing valuation surveyors and borrowers are not over-ambitious. Another snag is that ownership of residential property is not necessarily limited to the one property as it would be for the typical owner-occupier whether or not with second homes. With gearing and access to sources of funding, an investor can accumulate a portfolio of residential properties, thereby removing part of the supply and choice from the owner-occupation market.
Whether the trend in the residential property market is a drift away from owner-occupation towards the more flexible but relatively insecure shorter tenancy remains to be seen. There are arguments for and against owner-occupation, so too for being a tenant. Whatever the future holds, one thing is certain, the prices of residential property are generally more susceptible to froth and bubbles, and political interference.
In the commercial property market, the language of the market is different to that of residential property. Demand for premises is business-oriented which means tenant-thinking can be opaque and secretive, with each business plan not necessarily as dependent upon the particular premises as the landlord of those premises might think. Leases are commercial contracts which means the parties are deemed to know what they’re doing, including what they’ve let themselves in for. Legislation can and often does override the contractual agreement, but the concept of an unfair contract which features strongly in the consumer-oriented residential property market rarely figures in the less molly-coddled world of business tenancies. The difference in language between what landlords want and what tenant would agree is a battle of wits. Tenants are often more substantial and well-versed than the landlords of their properties, and even where the playing-field is level or the landlords more substantial, there may still be a tendency to be confrontational rather than co-operative.
Unlike the residential property market where the majority of homes are, in England and Wales, transacted by private treaty, subject to contract, the number of residential properties offered for sale by tender or auction in the minority, growth in the use of auctions for the sale and purchase of commercial property has overtaken private treaty, so much so that auctions are for most buyers and sellers the first and possibly the only port of call.
For sellers, auction offers an array of legitimate tricks and trade secrets that are used to maximise prices. My booklet ‘How to read an auction catalogue’ that I wrote during the 1980s is out of print but I have to be more circumspect nowadays! For buyers, it’s not only due diligence that is important, but also due care and attention. Unlike private treaty where the expression ‘subject to contract’ can imply slow motion with plenty of time to consider and reconsider, the period of time from obtaining the auction catalogue to the date of the auction might only be about 6-8 weeks during which time, despite the legal pack and viewing the property, a great deal of shrewd thinking is called for. Having settled upon a maximum bid for the lot, the next challenge is to avoid auction fever. With a “subject to contract’ transaction, initial excitement can fade, but in the atmosphere of the auction the excitement is stimulated, it is common for one’s resolve to soften and maximum bid exceeded. Having come so far, having invested a great deal of time and effort in a particular lot, an undisciplined investor is more likely to get carried away and continue bidding past the point of no return.
To suggest little or no return from commercial properties bought at auction in the current market might seem harsh to those seeking reassurance but actually that is precisely the fate that is likely to befall the average buyer at auction, even though they might not discover until years later. At present, the market is frothy. There is so much money chasing yield that the practical property consequences of what is bought do not appear to be of interest. Investment sentiment does not automatically translate into rental growth so assuming the proposition is funded soundly for the duration of the mortgage there is no reason, despite so-called upward-only rent reviews, why the return (yield) should increase, except by way of gradual repayment of the loan. Moreover, there is no reason, ignoring any other factors, other than sentiment and auction fever why anyone else should want to pay more for the proposition. All in all, a vast of money is pouring into the commercial property investment market almost it would seem for the sake of it.
Prices in the auction room do not, I repeat do NOT, reflect open market prices. Auction prices are only as good as the people present in the auction room, including telephone bidders, on that particular day and time who were interested enough in the lot and stimulated by the auctioneer’s adeptness to bid for it. Auction prices do not, contrary to the wording of a bank valuation report that I have received in connection with a matter I am dealing with, confirm that the liquidity of the asset has been demonstrated by the auction sale. Merely because buyer A paid £x does not mean that underbidder B would have also raised its bid to £x had underbidder B not dropped out, nor does it mean that there was anyone else in the room that would’ve bid as much as either A or B. All it means is that A bought the proposition for the price A paid.
At present, prices at auction for commercial property investments may be likened to the Government’s sell-off of shares in Royal Mail. The Government has been criticised for under-pricing shares in Royal Mail but that public conclusion can only be drawn with hindsight, as a consequence of what happened to the share price after the IPO. I suspect it very probable that the technical valuation of Royal Mail did not support a higher share price for flotation but where the government and/or its advisers are in my view open to criticism is in apparently ignoring investor sentiment. I am not going to stray into equity analysis, it’s not my field or place to do so, but I do know the same principle applies to commercial property investment: namely the difference between technical valuation and investor sentiment.
Investor sentiment and its impact on prices is difficult if not impossible to assess let alone gauge because so much depends upon whatever else is happening at the time, not only to the economy and other factors generally but also to the investor’s own circumstances. At present, interest rates continue to be low and despite mutterings from the Bank of England that seem to send economists into a shiver I reckon even a slight increase in Base Rate is unlikely to curb enthusiasm for commercial property investment. While a margin exists between borrowing rates and initial yield or where the opportunity is unique, there are sure to be people out there somewhere with the resources to continue buying. The attraction of the UK property market both to overseas and indigenous investors is an established and transparent legal system. The UK is regarded as a safe haven, a store of value in its own right. Despite property being an illiquid asset, it is considered there is ample liquidity in the system to support the level of sentiment. Where thinking like that can go awry is in associating the froth with technical investment. It is all very well reinforcing views around sentiment in order to reassure oneself of not having over-paid but the thing about bubbles is not that they might only be small while the market is simmering or that they get larger as the heat is turned up but that in the end they do have a habit of popping and taking their proponents with them by getting lost.
As I’ve said before, a paradox of higher prices is that better properties come up for sale. In a frothy market, the challenge in paying a frothy price to begin with is to ensure the proposition performs at the very least to the potential that the purchase price implies. The state of the investment market and the level of investor sentiment are not enough to provide that reassurance. Even if the market continues to improve and no reason, according to the pundits, to think otherwise, investment performance isn’t simply a matter of keeping up but also a consequence of skill and shrewd thinking by you and your advisers. Essentially, what you’re up against is tenant disinterest in the performance of your investment.