Background

This last blog on the COVID-19’s impact on Singapore real estate will seem very dark. I hope what has been written here does not come to fruition. However, I do feel compelled to opine that we need to spend time to seriously look into the situation when the socio-economic constructs begin to unravel. This piece looks at one aspect of Scenario 5 in the blog on the investment sales market. Scenario 5 can be triggered by a host of other factors and cross-factors. Here, we will approach it from a financial calculation angle.

How things can unravel

Much has been written about the impact of COVID-19 on societies and businesses and how it may change the landscape when it blows over. There is however a problem, a big one in fact, about all analysis that assumes that it blows over without any damage done to the underlying structure of the economy. What if it is here to stay and it supresses economic activity for a prolong period – e.g. for years – and policy inaction or dis-coordination starts to unravel the traditional economic constructs taught in economics/finance? Also, what if certain financial and economic fixed points move? Should these happen, investors could start turning negative and investment variables take on extreme values or behave in unexpected fashion.

For instance, on the private equity front, what if Limited Partners (LPs) stick to just their committed capital and resist future investments or, worse, end their commitments to future fund-raising exercises? On the corporate front, what if companies find that their current business models are out of synch with a COVID-norm world, resulting in them burning cash and needing a heavy dose of reinvestment to change course? On the private front, what if individuals find that risk taking is not preferred and instead turns to embracing risk free investments?

All this means governments, institutions, corporates and high net worth private individuals will shift from risk taking ventures to protecting their dry powder. There will be major withdrawals on many investment fronts. The result: asset price deflation. If nothing is done to prevent this, the combined actions of governments, companies and individuals may lead to a severe contraction in the price levels of many investment goods. There are many paths that can lead to deflation. One path can arise when governments need to reflate their economies to keep their society from breaking down. That may happen when investors (government, corporates and individuals) realize that the outbreak has no clear ending in sight. In graph 1, the “cut-off” point from investors’ need to invest to a cessation of investing is represented by two vertical lines. The red line is applied on the red curve when there is wholesale infection and the yellow line when there is expected a long-drawn battle of containment. For both cases, investors would probably be in the dark as to where rates of infection begin to decline (and so they have little knowledge of when it will get better). At the small interval ranges where the vertical lines are drawn, the final shape of the curve cannot be parameterized with confidence. This leaves markets with no handrails for guidance and markets hate uncertainties.

There is a possible third line(s) and that is when mixed curves begin to form for different countries. This can arise from uncoordinated attempts by various nations to approach the problem of infection or some earlier infected countries deciding to return to a travel as usual policy. This third line can be anywhere and is particularly dangerous because the parameters are even harder to determine. One cannot calculate its shape and thus also not being able to estimate when the infection rates will start declining. This is conceptually shown in the graph as the light blue coloured box that ranges across much of the graph. The vertical line(s) can therefore appear almost everywhere in this stylised diagram. We also don’t know when the vertical line would emerge, as it depends on the start of the breakdown of order and even less so on what shape mixed curves may take. When the breakdown occurs, its effects are similar to the dynamics in a Great Depression.

We are facing a very serious issue that can reverse the flow of capital to investments. We shall look at how investments can go wonky by approaching it from the mechanics of the discounted cash flow process to valuing real estate (I am focusing only on the asset class, but I am sure it can be used for others as well.)

What will go wrong with the DCF if the current financial-economic construct carries on?

1.Investment returns will have to rise to a level that investors will see it as worthwhile versus their expected capital spend to reflate their social-economic system. During the reflationary stage, reserves are drawn down. There will be hardly any inflow to the reserves. If the net spend is estimated to lead to an x% decline in reserves expected over a period of time in future, the returns of equity from investing will have to be greater than that. But do remember that the x% could be a very high number, leading to the need to high Internal Rates of Returns (IRR).

2.Interest rates may resist falling, much as the issue of bonds increase to fund their reflationary efforts. This may lead to higher real interest rates or add friction to rates coming down. As an illustration, S$9.7 billion SIA convertible bonds (the total to be raised is S$15 billion) is just the start of many such fund raising exercises across the globe.

3.Financial institutions, moving from a profit seeking objective to defending their credit ratings, focus on mitigating risks, lower their loan-to-value ratios and adopt a selective lending policy.

Combining points 1, 2 and 3 will mean that the cost of equity and cost of debt will rise substantially and on top of that the equity content will have to increase if banks lower their LTVs. This leads to an increase in the Weighted Average Cost of Capital (WACC). This result will be Net Present Values (NPV) coming off. The relation is found in the following equation.

4. Because of higher real interest rates and risk aversion, investors will need adequate compensation, and this should mean higher cost of equity. Looking at the cost of equity equation, it uses the appropriate long-term tenured government bond yield as the risk-free rate. But as the risk-free rate closes in on zero, any further lowering of interest rates will lose its efficacy in bringing down the cost of equity. Now here is where things get wonky. If the downturn is prolonged, what if the long-term government bond yield turns negative and what if the risk premium (market return less risk-free rate) also become negative? For the latter to happen, the expected returns from the equity markets is negative.

The mechanics of this is illustrated using this basic relation between the cost of equity in local currency terms and its various contributing components found in the right-hand side of the equation. This relationship is only well defined if the risk free is ≥ 0 and the market return is higher than the risk free rate.

Let us consider just two outliner possibilities.

• If the risk-free rate is zero and the market return is negative, then: Cost of Equity = β * (-Market Return)
• If the risk-free rate is negative and the market return is negative, then: Cost of Equity = - Risk Free Rate + β *(- Market Return + Risk Free Rate)

  Strange output values.

However, I feel that there are fundamental differences in the socio-economic structure between the US and the rest of the world e.g. the US runs huge budget and trade deficits whilst some in Asia run large surpluses, the US has been a technological leader and exporter while many in the rest of the world are adopters of their inventions, different pension funding systems, varied housing policies etc. If the risk premium is obtained from the equity markets, I prefer to calculate this from the performance of the STI to sterilise these differences. Also, because I do not subscribe to the view that the future is an extrapolation of the past, more question marks appear. The Singapore’s STI may have a long term positive trendline, but closer examination of its past 11 years’ performance shows that after the Global Financial Crisis (GFC), the STI growth profile appears to abide by a logistic growth curve rather than a straight line. (See Graph 2.) The slowing of equity price increases is corroborated by data from Singstat which showed that from 2009 to 2018 (the last available date), the Return on Equity (ROE) for main industries in Singapore has been declining. Graph 4 shows that the time series profile of the STI differs from the S&P 500 and NASDAQ. One may argue that over the long term, it doesn’t matter because all markets will be handcuffed to US risk premiums. But it doesn’t seem that way on the ground because having been embedded in the financial markets for a large part of my working life, each phase of the STI time series is driven by a different storyline from what is being narrated in the US. For instance, in the period 2013 to 2018, the STI was fanned by the spill-over from the bubbly performance of China linked companies listed here. (One can test this claim with a program that gathers and then cluster what market chatter had driven each market at the end of the day, week or month and then conduct a pairs test.)

If we accept that the market risk premium is expected to decline, the cost of equity declines accordingly. But if government bond yields remain sticky, there exists the possibility that the market risk premium turns negative and that can also lead to a negative cost of equity. But how can that be when in risk adverse times, the required return from equity investments should be even higher?

5. Deflation. This D is a “dirty” word that creates mischief in the discounting mechanism. In a deflationary environment, consumption is deferred until absolutely necessary and cash flow is expected to decline over time (when the top line falls faster than expenses). The rate of return from investments will have to be higher at the start to compensate for lower capital or investment income in the future. The effect of deflation can wreak havoc on terminal cap rates.

Terminal cap rate = Discount rate (r) – Long-term annual income growth rate (g)

If long-term annual income growth is expected to be negative, the terminal cap rate will be higher than if growth had been positive since:

Terminal cap rate = r* – (- g) = r*+ g

*: r can be the valuer’s choice of discount rate adopted during the term of the cash flow analysis or it can be the derived WACC used by business valuers.

A higher terminal cap rate, in conjunction with higher r’s used during the term of the discounted cash flows (because the cost of equity has increased and LTVs falling), would result in a lowering of asset values. In turn, collateral quality would deteriorate, leading to further credit tightening. This is the evil of deflation.

How deflation can take root is manifold. One path could be this: companies whose business models have been disrupted by COVID-19 may experience stepped down demand for their goods and services when this pandemic either blows over or becomes the norm in daily life. In other words, returns from historically committed investments decline. If the return falls faster than borrowing costs, or if the latter rise even a little, the spread falls. Trouble will begin to trickle down to housing demand, as employment will ultimately be affected. If risk adverseness spreads, funding for start-ups and the Gig economy will be even harder to come by. The long and short of it is that there will be price deflation and devaluation of real estate prices across most market segments (private housing, office, retail, hospitality and industrial). The 2 D words will be very difficult to counter for central bankers when they are intertwined with interacting issues that are expected to appear over time. The interference can limit the degrees of freedom where governments can counter them. For instance, if the push towards reducing CO2 emission takes on greater urgency and if weather changes causes a constant stream of uncertain events, conditions could emerge which could crimp the ability to implement or, even if applied, the effectiveness of policy actions.

Conclusion

The six points discussed are extremely disruptive to the real estate market. Combating its ill effects will need a global effort because in an intertwined investment world, unilateral efforts to fight it will result in arbitrage, annulling any well-intendedness. Policy makers will be grappling with inputs from many fronts but if we pay attention to the variables used in the discounted cash flow process, it filters off a lot of the noise and directs our focus of attention to action plans that seek to prevent the following:

• Adverse risk aversion from developing
• Difficulty in obtaining credit or reduction in LTVs. Rather, LTVs should increase
• Negative interest rates
• Deflation
• Sharp rise in the cost of equity
• Oversupply of future lands
• The continuation of the cooling measures in its current form

Yes. The fight requires bold action plans.

It is natural for some to ask what the S$55 billion budget boosters, one announced on 18th February and the other on the 26th of March, will do to the real estate market. The various assistance packages pronounced are generally consumption driven in nature and so the short answer is, not much, once the spend works through the money multiplier. Using the DCF method to illustrate its long-term influence on consumption, it is just an injection of cash and subtraction of expenses into one period of a multi-year cash flow model. Cash flow in the subsequent and the terminal years have not changed. The points that I raised pertain to the investment pillar of the economy, in which real estate is part of. The issues discussed are structural in nature and cannot be tackled by budgets or from the consumption side. Therefore, after tackling the immediate need to help the “human factor” in this pandemic, governments (as I mentioned, no single government can do this alone), must get their act together to ward off the evils of deflation.

Owing to the constraints of space, I will not use this platform to look at the options to fight deflation.