We seem to have entered a period of uncertainty - Markets hate uncertainty by Pastuszek

Bill Pastuszek, Shepherd Associates

We seem to have entered a period of uncertainty. Markets hate uncertainty. Okay, define uncertainty:

Un·cer·tain·ty. Noun: uncertainty: the state of being uncertain. That is to say: unpredictability, unreliability, riskiness, chanciness, precariousness, changeability, variability, inconstancy, fickleness, caprice , doubt, lack of certainty, indecision, irresolution, hesitancy, unsureness, doubtfulness, wavering, vacillation, equivocation, vagueness, haziness, ambivalence, lack of conviction, disquiet, wariness, chariness, leeriness, skepticism.

Antonyms: predictability, confidence.

How do investment real estate markets parse uncertainty? Generally, real estate investors will build some factor into their buying decisions to reflect uncertainty.

Investors, in general, can handle bad news such as rising interest rates or higher inflation. What investors don’t like is lack of the means to act decisively and the lack of the ability to hedge against a future that lacks clarity. The future is of course unpredictable. Investors, within limits, know that and thus some base risk is built into most investor behavior.

How do rising interest rates influence behavior? Lenders – they are investors too – build the risk of the higher cost of money into their underwriting. Equity investors will build higher interest rates into their buying decisions by adjusting the cap rates that result from the relationship of income to sales price.

Risk comes in different forms. Risk can be generated by market fluctuation, interest rates, availability of capital, asset/tenant quality, competition, environment, political instability, among others. Most investors leverage their investment through financing. Leverage shields them from taking on the full brunt of market changes. Leverage, and so their rates of return, are affected when interest rates change. While investors – equity and debt – surely don’t know the direction of interest rates, they want to have some consensus in the market so that their behavior is in step with that of other investors.

Cash buyers take the brunt of the market. When there is no leverage, there is no cover. This investor type tends to be fairly careful about risk and the markets’ unpredictability.

Higher costs of money mean potentially higher cap rates. If the cost of money is recognized in a cap rate (and it doesn’t always appear to be in superheated markets), higher costs of money will lead to a higher cap rate, thus resulting in higher risk.

If investors want to keep cap rates constant (or, in super-heated markets, continue compressing rates), then equity has to be willing to accept a lower return, at least in the short term.

In speculative markets, investors wishing to buy under any circumstances will accept a lower short term return, assuming that continued appreciation and demand will result in a pot of gold at the end of the rainbow.

When the market stops appreciating (and there are signs clearly in some sectors that this may be happening), what seemed like a good idea ends with straightened cash flow and difficulty refinancing. If the market gets really bad, both equity and debt positions get further compromised, with only unpleasant consequences.

For a prudent investor, higher debt costs translate into more risk adverse positions. In uncertain markets, the equity component is adjusted appropriately for the lack of clarity and a higher level of risk.

So, where are we in this cycle? One colleague said, cleverly, “It’s 10 minutes before midnight, but they keeping moving the stroke of midnight back. Eventually, they won’t be able to do that and the clock will strike.”

Another colleague characterized real estate markets as large container ships. They move well when the course is set. When it is necessary to change course, it takes them a long time to do that and sometimes are unable to get to the new heading.

These are uncertain times. As a wise person has said “uncertainty about the future is always bad for morale.” For sure, and, moreover, we’re not entirely sure we believe what the nav tells us. Yes, and, what if the clock struck 12 and we didn’t hear it?

Bill Pastuszek, MAI, ASA, MRA, heads Shepherd Associates, Newton, Mass.