Nature of Property Cycles: Past, Present and Future

9 th May 217 Nature of Property Cycles: Past, Present and Future Robin Goodchild MA PhD FRICS International Director, Global Research & Strategy and Visiting Professor, University of Aberdeen Business School

Nature of Property Cycles : Past, Present and Future Agenda The Past: pre-214 Nature of Cycles in the UK and other Markets Academic Literature The Present: 214-Today What is the nature of the current cycle? Similarities and Differences The Future: The Next Decade Understanding the causes of cyclicality - lessons learned Can the Credit Cycle be tamed? Conclusions and Forecasts LaSalle Investment Management Nature of Property Cycles CULS / IPF / SPR 2

The Past: (pre-214) LaSalle Investment Management Nature of Property Cycles CULS / IPF / SPR 3

UK Property 1968-213: Three Significant Cycles 2 UK All Property Real Capital Value change % pa 15 1 5-5 -1-15 -2-25 -3-35 1968 1972 1976 198 1984 1988 1992 1996 2 24 28 212 Sources: LaSalle, MSCI LaSalle Investment Management Nature of Property Cycles CULS / IPF / SPR 4

UK Property 1968-213: Three Significant Cycles 2 15 1972-76 UK All Property Real Capital Value change % pa 24-9 1 5-5 -1-15 -2-25 -3 1987-92 -35 1968 1972 1976 198 1984 1988 1992 1996 2 24 28 212 Sources: LaSalle, MSCI, LaSalle Investment Management Nature of Property Cycles CULS / IPF / SPR 5

Developed Markets show similar cyclical pattern 198-216 Annual Capital Value Change (local currencies) 2% 1% % -1% -2% -3% Australia UK US 1981 1984 1987 199 1993 1996 1999 22 25 28 211 214 Source: IPD (Australia, UK), NCREIF (US) Data through 213 LaSalle Investment Management Nature of Property Cycles CULS / IPF / SPR 6

1976 = 1 inflation adjusted All Real Estate Markets are Cyclical Real Office Values in Major Global Markets 6 5 New York Frankfurt Stockholm Tokyo Sydney Singapore London City 4 3 2 1 Sources: PMA, Wheaton & Barranski, Vallis, Devaney, Turvey, RICS, Bjorklund & Soderberg LaSalle Investment Management Nature of Property Cycles CULS / IPF / SPR 7

1976 = 1 inflation adjusted All Real Estate Markets are Cyclical Real Office Values in Major Global Markets: Especially Volatile in Hong Kong! 9 8 New York Frankfurt Stockholm Hong Kong Tokyo Sydney Singapore London City 7 6 5 4 3 2 1 Sources: PMA, Wheaton & Barranski, Vallis, Devaney, Turvey, RICS, Bjorklund & Soderberg LaSalle Investment Management Nature of Property Cycles CULS / IPF / SPR 8

Example from UK: Property Cycles 1968-213 'Equilibrium 211? 1995-23 1979-86 Real Rental Growth % pa 5. Real Capital Growth % pa. -35. -3. -25. -2. -15. -1. -5.. 5. 1. 15. 2. 15. 1. -5. Boom 24-6 1987-8 1972-3 Bust 27-9 1974-6 199-2 Sources: MSCI/IPD, LaSalle Investment Management -1. -15. Recovery 21 1993-4 1977-8 LaSalle Investment Management Nature of Property Cycles CULS / IPF / SPR 99

Decomposing UK Property Cycles A Comparison of Three Cycles Real Capital Value change % Real Rental Value change % 3 4 2 3 1-1 -2 Booms Busts Recoveries 2 1 Booms Busts Recoveries -3-1 -4-2 -5 197s Late 198s GFC -3 197s Late 198s GFC Sources: MSCI/IPD, LaSalle Investment Management LaSalle Investment Management Nature of Property Cycles CULS / IPF / SPR 11

What else does this tell us? 28/9 was not exceptional in real estate terms (at least in the UK) 16-18 years between cycles is that just a coincidence? Types of economic cycles: Kitchin: 3-5 years inventories Juglar: 7-11 years fixed investment (business cycle) Kuznets: 15-25 years infrastructure investment (18 year US property cycle - Foldvary 1997; 15-25 years in UK Barras 29) Kondratiev Waves: 45-6 years technological changes / financial manias? Cracking Stories: Early 197s Plender, J (1982) Late 198s Ross Goobey, A (1992) GFC Big Short etc.(& World Economic Forum (215)) LaSalle Investment Management Nature of Property Cycles CULS / IPF / SPR 12

The Present: 214 - Today

UK Property 1968-216: The Present Did we experience a Boom in 214/15 so are we now about to have a Bust? 2 15 1 5-5 -1-15 -2-25 -3 UK All Property Real Capital Value change % pa -35 1968 1972 1976 198 1984 1988 1992 1996 2 24 28 212 216 Sources: LaSalle, MSCI

UK Property Transaction Volumes: The Present The Pattern of Transactions looks suspiciously like 25/7 Value and Number of Commercial Property Deals in March of Each Year Sources: Property Archive, Capital Economics LaSalle Investment Management Nature of Property Cycles CULS / IPF / SPR 15

Decomposing UK Property Cycles Capital Gain in 214/15 not sufficient to be a Boom Real Capital Value change % Real Rental Value change % 35 35 3 3 25 25 2 2 15 1 15 1 5 5 Booms 197s Late 198s GFC 214/15-5 Booms 197s Late 198s GFC 214/15 Sources: MSCI/IPD, LaSalle Investment Management LaSalle Investment Management Nature of Property Cycles CULS / IPF / SPR 16

Yields % UK Asset Class Yields 1975-217 Q1 Spread between Property & Gilts has never been wider 16 14 12 1 UK All Property Yield 1-year Gilt FTSE Dividend Yield Prime West End Office Yield 2-year index-linked Gilt 16 14 12 1 8 6 4 2 8 6 4 2-2 1975 1978 1981 1984 1987 199 1993 1996 1999 22 25 28 211 214 217 Q1-2 Sources: Thomson Reuters (Datastream), CBRE, LaSalle Investment Management LaSalle Investment Management Nature of Property Cycles CULS / IPF / SPR 17

Interest Rate % But the Post-War period is an Aberration relative to history What is a normal level for the Risk Free Rate? 16 14 Yield on Consols 17-215 (undated Government bonds) 12 1 8 6 4 2 17 172 174 176 178 18 182 184 186 188 19 192 194 196 198 2 Sources: Bank of England, PMA LaSalle Investment Management Nature of Property Cycles CULS / IPF / SPR 18

The Future What drives Property Cycles

UK Property Cycles 1968-216: Three Significant Ones Strong relationship between Property Returns and Economic Growth 3 2 1-1 -2 1 8 6 4 2-2 -4-6 -8-3 -1 1968 1972 1976 198 1984 1988 1992 1996 2 24 28 212 216 Total UK Commercial Property Real Returns % pa GDP % pa (RHS) Sources: LaSalle, MSCI, ONS

Economic Downturns don t have to cause a Property Bust Big Cycles have occurred every second Economic Downturn 3 2 1-1 -2 1974/5 198/1 199/2 21/2 28/9 1 8 6 4 2-2 -4-6 -8-3 -1 1968 1972 1976 198 1984 1988 1992 1996 2 24 28 212 216 Total UK Commercial Property Real Returns % pa GDP % pa (RHS) Sources: LaSalle, MSCI, ONS

UK Office Construction Output: Constant 213 prices million Too much office development can also be problematic UK Office development 198-216 4,5 4, 3,5 3, 2,5 2, 1,5 1, Feb-8 Feb-84 Feb-88 Feb-92 Feb-96 Feb- Feb-4 Feb-8 Feb-12 Feb-16 Sources: LaSalle, BCIS, ONS LaSalle Investment Management Nature of Property Cycles CULS / IPF / SPR 22

UK Lending to Corporate Real Estate Highly correlated with the 3 Cyclical Peaks LaSalle Investment Management Nature of Property Cycles CULS / IPF / SPR 23

How the Building Cycle works Real Economy Property Market Fundamentals Capital Markets Recovery Credit Expansion Increasing property demand Falling vacancy Rising rents/falling yields Upswing in building starts Prosperity Multiplier + Speculative building boom Accelerator + Credit boom Rising construction costs Recession Increasing supply and slackening demand Credit tightening Rising vacancy Falling rents/rising yields Downswing in building starts Depression Source: Barras (29) p 8 Multiplier - Property slump Credit crunch Accelerator - LaSalle Investment Management Nature of Property Cycles CULS / IPF / SPR 24

Economic Downturns don t have to cause a Property Bust Big Cycles have occurred every second Economic Downturn 3 2 1-1 -2 1974/5 198/1 199/2 21/2 28/9 1 8 6 4 2-2 -4-6 -8-3 -1 1968 1972 1976 198 1984 1988 1992 1996 2 24 28 212 216 Total UK Commercial Property Real Returns % pa GDP % pa (RHS) But no accident that worst recessions usually coincide with the Busts Sources: LaSalle, MSCI, ONS LaSalle Investment Management Nature of Property Cycles CULS / IPF / SPR 25

% Loss Rates on Loans Why is CRE lending so cyclical? Write-off rates on lending to UK businesses 2.5 2. 1.5 1..5 Time and again financial earthquakes are thrown up by excessive risk taking on borrowed money in property. Indeed, property seems to have a unique capacity for inducing collective memory loss among bankers. John Plender FT 2/5/217. 1994 1996 1998 2 22 24 26 28 21 212 Private non-financial corporations Commercial real estate companies Lending by UK monetary financial institutions. The series are calculated as annualised quarterly write-offs divided by the corresponding loans outstanding at the end of the previous quarter. The data are presented as four-quarter moving averages and are non seasonally adjusted. Lending in both sterling and foreign currency, expressed in sterling terms. Source: Bank of England and Bank calculations LaSalle Investment Management Nature of Property Cycles CULS / IPF / SPR 26

Billions USD Total Volume Billions USD Similar data for USA show GFC explosion in Loss Ratio Delinquency Levels for US CMBS loans 2-15 8 8 6 6 4 4 2 2 2 22 24 26 28 21 212 214 3 Days 6/9+ Days Non Performing Beyond Maturity Foreclosure/REO Total Loan Volume (right scale) Source: Trepp LLC LaSalle Investment Management Nature of Property Cycles CULS / IPF / SPR 27

Some lessons from three big Property Cycles Debt driven real estate markets are dangerous Contradiction between prudent lending and building a market leading banking business in commercial real estate Too much development is also dangerous Greed and Fear rule - pay attention to Behavioural Economics Property looks a very easy business in a Boom Beware managers in senior positions who have not experienced a Big Cycle If commercial property values increase by over 25% real (in a 2/3 year period) - there is a very high probability of a Bust Ways to exploit property cycles Catching the falling knife - buy in the Bust to exploit the Recovery bounce Long term investing between big cycles selling into the next Boom LaSalle Investment Management Nature of Property Cycles CULS / IPF / SPR 28

% of Bank Lending to CRE Real Capital Values Index (1969 = 1) UK Commercial Real Estate (CRE) Lending 1969-216 The current situation looks comfortable, i.e. mid-cycle Bank Lending to CRE as a % of all Lending 14 Bank Lending % All Property Real Capital Values 16 12 14 1 12 8 6 1 8 6 4 4 2 2 1969 1974 1979 1984 1989 1994 1999 24 29 214 Sources: Bank of England, MSCI/IPD LaSalle Investment Management Nature of Property Cycles CULS / IPF / SPR 29

So: When will the next Big Cycle occur? circa 225 or some other date Pros 16-18 years from 27/8 Time for professionals without experience of a Big Cycle to reach positions of seniority Debt market is attracting new players who may not have any institutional memory Bank of England will not be sufficiently brave to remove the punch bowl in time (as in 1986/7 and 25/6) Cons The 28/9 crash was so devastating that its effects will stay longer in corporate memories Better information about real estate markets will prevent a recurrence: - Property Vision report recommendations: Long term valuations Loan data Recovery from the GFC will be so muted that there is not enough confidence to generate a Boom (cf. recovery from 193s) Better education CULS, IPF and SPR achieve their mission LaSalle Investment Management Nature of Property Cycles CULS / IPF / SPR 3

Bank of England s Investment Valuation Approach (Q2 215) Sources: Association of Real Estate Funds (AREF), Bloomberg, Investment Property Forum, MSCI and Bank of England calculations. Investment valuations are based on assuming property is held for five years with the cash flows from the rent and sale discounted. It is assumed that the property is sold at a rental yield (in line with long-run averages fifteen years). The sale proceeds and rental income are discounted by the ten-year gilt yield plus a risk premium. The swathe represents varying assumptions on the average through the cycle risk premium, given the inherent uncertainty in measuring it; the lower end of the range is from a survey of investors from AREF and the higher end is a risk premium derived from the long-run relationship between gilt yields and property yields. For more details see Crosby et al. (211), LaSalle Investment Management Nature of Property Cycles CULS / IPF / SPR 31

Nature of Property Cycles : Past, Present and Future Conclusions and Forecasts The Past: pre-214 Property Cycles have a very long history Four market phases Boom, Bust, Recovery & Equilibrium Key causes: Combination of Economic, Debt Availability, Excess Development and Memory The Present: 214-Today Strong Equity Driven upswing but not a Boom Market likely to remain in Equilibrium, i.e. no Bust The Future: The Next Decade A Big Cycle around 225 is not inevitable but.. LaSalle Investment Management Nature of Property Cycles CULS / IPF / SPR 32

Final Thoughts: Hope over Experience Whenever the [new cycle] starts, there will be new participants, who will be less constrained by the experience of this recession than those who lived through it. They will repeat many of the mistakes of the 198s, as many of the companies repeated the mistakes of the 197s. The market will then be driven to levels which will prove unsustainable. Ross Goobey, A (1992) LaSalle Investment Management Nature of Property Cycles CULS / IPF / SPR 33

Contact details: Robin Goodchild PhD FRICS E-mail robin.goodchild@lasalle.com References: Barras R (29) Building Cycles Growth & Instability Wiley-Blackwell, West Sussex, UK Benford, J & Burrows, J (213) Commercial property and financial stability Bank of England Quarterly Bulletin Q1 pp 48-53 Cosmetatos, P (216) Improving the effectiveness of CRE debt risk management, Chapter 21 in Petersen, A (Editor) (216) Commercial Mortgage Loans and CMBS: Developments in the European Market 3rd Edition, Sweet & Maxwell, London Crosby, N and Hughes, C (211), The basis of valuations for secured commercial property lending in the UK, Journal or European Real Estate Research, Vol. 4, No. 3, pages 225 42. Foldvary, F. (1997) "The Business Cycle: A Georgist-Austrian Synthesis." American Journal of Economics and Sociology 56 (4) (October): pp 521-41. Goodchild, R (215) Property Cycles: Reflections by Dr Robin Goodchild LaSalle Investment Management, Chicago http://www.lasalle.com/documents/global-real-estate-universe-february-215.pdf Goodchild, R (216) Nature of Property Cycles, Chapter 2 in Petersen, A (Editor) (216) Commercial Mortgage Loans and CMBS: Developments in the European Market 3 rd Edition, Sweet & Maxwell, London Korotayev, A, & Tsirel, S (21) A Spectral Analysis of World GDP Dynamics: Kondratieff Waves, Kuznets Swings, Juglar and Kitchin Cycles in Global Economic Development, and the 28 29 Economic Crisis Structure and Dynamics Vol.4. #1. P.3-57 Ormerod, P (1994) The Death of Economics Wiley, London Plender, J (1982) That s the way the money goes The Financial institutions and the Nation s Savings Andre Deutsche, London Real Estate Finance Group (214) A Vision for Real Estate Finance in the UK Investment Property Forum, London Ross Goobey, A (1992) Bricks and Mortals: Dreams of the 8s and the Nightmare of the 9s Inside Story of the Property World Random House Business Book, London Trepp LLC (216) The Mid Year CRE Market on the High Wire Commercial Real Estate Direct, Doylestown PA, USA Wolf, M (214) The Shifts and the Shocks: What We ve Learned and Have Still to Learn from the Financial Crisis Penguin Group, New York World Economic Forum (215) Emerging Horizons in Real Estate: An Industry Initiative on Asset Price Dynamics, Executive Case Studies WEF, Geneva LaSalle Investment Management Nature of Property Cycles CULS / IPF / SPR 34

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