In recent years, the property market has seen unprecedented and persistent hikes in both prices and transaction volumes, but for the first time in 7 years, we foresee a decline in transaction volume. This may seem paradoxical inasmuch as investors in recent years have professed to have a stronger appetite for added exposure to real property. We have looked into the causes of the observed decline in transaction volume, asking also whether or not the ECB’s decision to cease its bond purchase programme has had or is likely to have any major effect on this decline. Most likely, this is not the case, as the decline in liquidity seen in the property market this year seems to be caused by something quite different.
Rate hikes not expected to have any short-term effect on prices and transaction volume
The focus on monetary policies and the interest rate level determined by both Danmarks Nationalbank and the ECB is ever-increasing. As Denmark has adopted a fixed rate policy involving a DKK-EUR peg, Danish interest rates are tied to monetary measures implemented by the ECB. The general consensus is that we will see budding signs of rate hikes in the years ahead. However, we do not believe that rate hikes driven by growth and inflation will per se have any material impact on pricing mechanisms in today’s market.
ECB ceases bond purchase programme
By comparison, we find the ECB’s recent announcement concerning its bond purchase programme much more interesting. In June this year, the ECB announced a 50% reduction of its bond purchase programme, followed by a complete stop at year-end 2018. Until last year amounting to as much as EUR 60bn on a monthly basis, the massive purchases have kickstarted financial markets by injecting vast amounts of capital into the system. Generally speaking, this capital has been invested in securities and other asset classes, including real property, boosting liquidity in the respective markets.
Following the stop to the purchase programme, bond market supply is expected to increase. However, the increase in supply is believed to be snapped up by institutional investors seeking to allocate more funds to bonds at the expense of other asset classes, for instance properties.
The spillover effect of the ECB’s decision is not easily quantifiable across borders and markets, but by comparing the annual volume of bond purchases in 2017 (approximately DKK 5,350bn) with the same year’s aggregate volume of property transactions in Europe (approximately DKK 2,390bn), you get at pretty good idea of the former scale of the purchase programme. Supposing that just 5% of the increase in bond supply is funnelled away from the property market, this suggests a decline of DKK 268bn in capital allocations, equivalent to just above 10% of overall property transaction volume.
Is a sharp drop in property market liquidity imminent?
The short answer is no. Seen in isolation, we do not expect that a stop to the ECB’s purchase programme will translate into a significant drop in property market liquidity in the short term. Nevertheless, we believe that investors active in particular in more secondary markets should be on the alert and aware that this could especially affect liquidity in these markets.
Although a decline in capital allocations to real property in theory reduces liquidity, we are witnessing two market trends that support the opposite in the short term, at least in terms of prime markets in and around major towns and cities:
1. Recent years’ monetary policies have served to foster substantial placement requirements, with an increasing number of investors, including domestic pension funds, proclaiming to have an appetite for increased property market exposure. These placement requirements have implicitly caused demand to surge for prime (first-class) office and residential property in particular, where supply has been altogether unable to match demand.
Stronger competition for properties in these markets has prompted substantial price hikes in recent years, driven mainly by yield compression. Sell-side price expectations have now reached a point where investors to an increasing extent are doubting whether they will in fact achieve a satisfactory risk and illiquidity premium on their property investments.
Although capital placement requirements support a transaction volume that exceeds the present level, sell-side price expectations have in several instances seen a steeper rate of increase than those on the buy side. This ties in with the fact that, when faced with high asking prices, buyers are more prone to simply discarding given property investments. As a result, the 2018 transaction volume in the investment property market is expected to fall short of the level suggested by indicated allocations to real property.
The transaction volume is therefore believed to be below the theoretically feasible level given the current amount of capital allocated to property investments. Weaker demand for property would therefore have little bearing on liquidity levels in the short term.
2. High sell-side price expectations in prime markets have increasingly caused capital allocations to spill over to secondary markets, motivated by massive capital placement requirements and the pursuit of the highest risk-adjusted returns.
This trend has been particularly prevalent in the past 18-24 months, when we have seen a higher transaction volume in the secondary markets for e.g. office and retail property. Investors have turned out to be more risk-tolerant than before, having now moved further out the risk curve to obtain the required returns.
Similarly, because of the spillover effect in secondary markets, these markets are expected to be hit by a possible liquidity shortfall prompted by reduced capital placement requirements. This is due to the fact that often investors in these markets have already shifted focus from their core capabilities and original investment target. As a result, they are also expected to start by removing the secondary markets from their short list.
Unrealistic price expectations inhibit liquidity, not lack of capital
As mentioned, we have this year seen a slight decline in transaction volume relative to 2017, which was a record-breaking year. Theoretically speaking, and based on past market observations, a drop in transaction volume may herald a downtrend in prices – often with some delay, for instance a lag of 12 to 24 months. So far, however, we have not seen any signs of prices actually downtrending due to a decline or stagnation in transaction volume. This suggests that the amount of capital in the market is not the current determinant of liquidity. Instead, we argue that sell-side price expectations in many instances may be seen as unrealistic based on risk-adjusted return considerations. This has inhibited liquidity levels in the past 12 months.
It is important to understand how weaker liquidity could affect the investment market as this represents a risk often overlooked in today’s market because of the prevailing focus on the effect of rate hikes. Based on our assessment that interest rates will remain relatively low for some time yet, we advise investors to monitor movements in market liquidity too and to get an understanding of its drivers as this may serve to give a fairer indication of market balance and whether or not pricing may come under pressure.