• Christian Schitton

Risk Management in Booming Real Estate Markets

Risk Management Systems, in particular Predictive Analytics Tools, are constantly watching out for early warning signals which could indicate the change in a market development. This is even more important in alternative investment segments like real estate as the time period from observing a signal to readjusting the portfolio can be quite a consuming one.


In this context, looking at the "right" market parameters, their associations and inherent dependencies is helpful to get at least a notion, already in an early stage, of the embedded market dynamics and their impact on the own portfolio in terms of risk exposures and in terms of market opportunities.


One of those notions is the existence of market clusters in certain geographical areas. Market clusters which are not addressed properly can run contrary to any diversification efforts and may cause very unpleasant results. We talked about this in some previous articles.


Here, we deal with another scope of potential early signals.



The Minsky Moment


When does a market break? Can we see relevant signals beforehand which would give decision makers time to act and adapt their risk positions?


Hyman P. Minsky gave invaluable insights into fragile economic systems which is often subsumed as the Minsky Moment (references below). In fact, his work is so broad that one cannot distill the results in one simple "moment", nor can it be spread out in one single article.


Nevertheless, his work gives a lot of points of intersection to be considered when talking about risk management systems and predictive analytics.


One of those interfaces is the instability in Investment Markets. Minsky argues:


"The stability of the economy depends upon the way investment and positions in capital assets are financed. [...] Our economy is not unstable because it is shocked by oil, wars, or monetary surprises, but because of its nature."


Further, Minsky goes on:


"Demand for capital assets is determined by their expected profitability. In an economy in which the debt financing of positions in capital and financial assets is possible, there is an irreducible speculative element, for the extent of debt-financing of positions and the instruments used in such financing reflect the willingness of businessmen and bankers to speculate on future cash flows and financial market conditions.


During periods of tranquil expansion, profit-seeking financial institutions invent and reinvent 'new' forms of money, substitutes for money in portfolio, and financing techniques for various types of activity: financial innovation is a characteristic of our economy in good times.


Financial innovation therefore tends to induce capital gains, increase investment and increase profits: the economy will try to expand beyond any tranquil full-employment state."


This new type of financing can mean a really new, inventive class of funding or and old one that is used to a much greater extent than in previous periods. In any case, those inventions create money which lead to more investments.


This rise in spending on investments allows for a further increase in profits which reconfirms the investment and funding behaviour. With this feedback loop, the price of capital assets continuous to rise and finally it all ends up in an investment boom.


According to Minsky, this investment boom - after passing some tipping point - will trigger inflation. Problem is that this inflationary boom will cause financial structures which are prone to financial crisis.


In other words, as soon as an externally financed investment boom takes place the changing financial relations - fueled by new inventions in the financing sector respectively by the extensive use of already existing financial tools - will move to a framework with increased speculative financing of positions.


This in turn will lead to conditions susceptible to a crisis. At the end of this development, one faces financial structures in which debt deflation can take place. Though, those structures were already built up during the boom phase.



Junk Bonds and Mortgage Backed Securities


High-yield bonds (also called junk bonds) were THE financial innovation of the early 1980s. In fact, those finance tools existed already before but were used extensively during this decade. The junk bond market grew from USD 10 billions in 1979 to USD 189 billions by the year 1989.


This financial instrument fueled the investment market, more precisely the takeover market of the 80s. Which kind of inflationary effect junk bonds had on takeover prices, you can see by just following the case of RJR Nabisco which was subject to an intended management buy-out at a rather modest price (around USD 24 per share) but ended up in a takeover battle won by KKR at significantly higher prices (around USD 108 per share).


This all happened within months and were backed by the expectation that purchase prices will be easily funded by junk bonds.


Problem was that in the ongoing booming market not all of the investments financed by these high-yield bonds targeted solid assets. Instead, speculation started to prevail. Another issue came from the fact that some of the dominant players in the junk bond issuing industry showed fraudulent behaviour.


And as those cracks surfaced, the junk bond market evaporated practically overnight leaving the takeover industry belly up.

 

Another example of a financing tool extensively used and therefore fueling a whole market segment is mortgage backed securities driving the subprime market.


In short, the idea was to finance assets, in this case residential assets. Those financings were pooled in mortgage backed securities (MBS) sliced up in different rating classes and sold to third party investors. The security of the mortgaged backed security came from the diversification as a lot of financed assets were pooled in one instrument and by the market value of the assets themselves (which were constantly rising anyway).


The grade of this security was determined by the rating class of the MBS slice and hence, by its repayment profile.


This financing tool pushed investments in those markets, earnings were great and more investments pushed the prices of the assets even further. In order to keep the flow running, the financing of residential assets were more and more opened to borrowers with a low credit rating. Financing terms allowed for a grace period or low repayment terms in the beginning of the financing. Hence, the incorporated low capabilities of repaying the loans were not seen immediately.


Nevertheless, at one point default rates in the subprime market skyrocketed and the market learned that even triple A slices of those MBS were not secure at all as asset values slumped much more rapidly than it was anticipated in standard risk models (backing the prices of those MBS tranches).


The newly invented financing tool "mortgage backed securities" failed and sent a whole market into the abyss. This and due to the nature of connected investment and financing markets, it all ended up with the big financial crisis of 2007 to 2009.



Real Estate Corporate Bonds


As from ending the financial crisis, real estate markets in Europe (and a lot of other areas) started to move into a significant booming stage. Investment yields are meanwhile at low levels never seen before.


One of the causes of this development was for sure the generally low interest rate levels and the search for higher yield options that investments in real estate could offer.


This is even more striking as the main source of real estate financing, the classic real estate debt financing via banks and financial institutions, partly dried up. As a consequence of the financial meltdown, requirements by banks towards borrowers got much more stringent. Additionally, for banks to maintain real estate debt exposures got much more expensive.


In this situation, we saw the advent of corporate bonds also in the European real estate sector. Corporate bonds in itself were not a fresh funding tool. Though, the progressive use of this financial instrument in the real estate business was new.


According to Legal & General Investment Management (LGIM) , the portion of the real estate sector in Europe's bond market grew from a mere 1 % to approximately 6 % in just one decade. Not to forget, this increase happened in an anyway expanding bond market.


In nominal terms, this means an increase from below EURO 15 billions to over EURO 160 billions.


I think it is save to say that at least part of the booming European real estate market was driven by the extensive use of the financial tool 'corporate bonds'.


With this development comes a shift in the financial structure of real estate companies.


A classic real estate loan was usually directly linked to the asset financed. The loan was collateralised by that very asset and incorporated covenants took care that the loan was kept within boundaries in terms of loan to market value - ratios as well as debt service - ratios. Usually, a portion of the loan had to be repaid during the credit term.


With corporate bonds, the financing moved from the asset level to the corporation level. So, the funding is somehow detached from the financed asset. Terms, pricing and attractiveness of a bond tranche is primarily influenced by the rating of the corporation. Issued bonds are partly not collateralised. Repayment is done at the end of the bond term.



Financially Fragile Markets


MInsky talks about three basic types of Cash Flow

  • income: Cash Flows from operations;

  • balance sheet: Cash Flows which are pre-determined by existing liabilities;

  • portfolio: Cash Flows which come from acquiring or selling assets or from new liabilities put into circulation;

What makes a market system or financial system prone to disruption is the relative weight of those three Cash Flows in that very system.


When balance sheet commitments are primarily met by income Cash Flows, the system seems quite resilient. In case portfolio transactions are widely used to obtain the means for making balance sheet payments, the market is at least potentially financially fragile.


Summarising for the European real estate markets, there is the financial instrument 'corporate bonds' which has been extensively used as from the end of the big financial crisis. This caused a shift in the financial structure of corporations from the more traditional and project focused bank lending towards a rating focused bond financing with different collateral and repayment structures.


European real estate markets are booming and an important factor in corporations' profit & loss accounts are revaluation gains and as a final consequence, indicating the shift from Income Cash Flows to Portfolio Cash Flows in order to meet Balance Sheet Cash Flows.


Apart from this, the shifting focus towards corporate rating can cut both ways as well. At those low real estate investment yield levels we currently face in most of the major European areas, already a slight move in the wrong yield direction may give a fatal signal in the bond issuing market. Reason is that nominal asset values would deflate significantly already with small moves in the yield level (we talked about this problem in one of our previous articles: see references below).


Not to talk about corporate bonds showing their flaws by companies not meeting their coupon obligations or failing to repay/ refinance their bond tranches in time. China with its troubled real estate developers like Evergrande Real Estate Group, Sinic Holdings (Group) Co Ltd or Fantasia Holdings Group could arrange for a first impression.



Risk Management Tasks


The point I would like to transport is that already during the booming phase of a market, the ingredients for potentially fragile market conditions are incorporated.


Have a look at the European real estate markets in connection with the extensively used financial instrument 'corporate bonds'. A tipping point could be reached in that way that a few unfavourable events may be enough to send the markets south in their own momentum.


Though, instead of giving relentless warnings that markets could break, the task of a risk management system is to monitor the processes which could lead to this tipping point and to incorporate potential signals in their predictive decision making process. This should give enough space to decision makers to readjust their risk positions or to prepare for market opportunities in due time.


Relentless warnings that something could happen is like the broken watch which is correct two times a day. After all, the breaking of fragile markets and the imploding of market bubbles can take quite a long time. Why it usually takes longer is due to several reasons and will be handled in one of the next articles. Issue is that being too cautious in a too early stage, could mean missing out opportunities. Being too late, well...


And even then, when a market breaks then it does not necessarily mean that the big crash follows. After all, big crashes are still a rare event. Minsky:


"Whether the break in the boom leads to a financial crisis, debt deflation, and deep depression or to a nontraumatic recession depends upon the overall liquidity of the economy, the relative size of the government sector, and the extent of lender-of-last-resort action by the [Federal Reserve]. Thus, the outcome of a contraction is determined by structural characteristics and by policy."


This is how we see it at D-DARKS: No doomsday prophecies but creating a risk management framework which gives the strategic support for decision makers in order to be able to act in due time.



References


Stabilizing An Unstable Economy by Hyman P. Minsky, 2008


The History of High-Yield Bond Meltdowns by Daniel Jark, published in Investopedia/ July 6, 2020


Junk Bonds: a Financial Revolution That Failed by Jonathan Peterson published in Los Angeles Times/ November 22, 1990


Den Of Thieves by James B Stewart, 2012


Barbarians At The Gate: The Fall of RJR Nabisco by Bryan Burrough and John Helyar, 2010


Real-estate corporate bonds: follow the flow by Marc Rovers published in The LGIM blog/ October 7, 2021


Market Correction in Alternatives/ Real Estate by Christian Schitton published in Analytics Vidhya/ September 15, 2021