What caught my eye this week.

I can’t believe it’s 10 years since those crazy weeks of 2008, when the fall of the US bank Lehman Brothers took the global financial system to the edge.

But I guess I have my own additional reasons to feel this way.

At the height of the financial crisis, my father was unconscious in intensive care. He’d had a massive heart attack, but somehow survived it.

In our last conversation he’d gently ribbed me with the news that Lloyds had swooped for HBOS. In the previous one I’d mentioned that I couldn’t get into the share dealing account I held with the latter because its entire website had ground to a halt.

“Oh well, it’s only money,” he’d said, more or less. Typically.

My then near-secret passion of the stock market and the runaway train of real-life had collided and blown up in front of me – in the headlines, in a hospital, in my portfolio, on my mind, all the time. For what seemed like an eternity but was only really a week or so, I was propped up at all hours distracting myself reading The Snowball in some hidden corner of the hospital. I’d buy a couple of newspapers from the reception area each morning – the FT and a changing companion – to keep track of the other drama going on in the world.

My dad’s heart machine bleeped, but that was about it. Day after day.

Bleep. Bleep.

I count myself fortunate to have been away from any TV during 9/11, and I was also without Bloomberg or CNBC – or much of an Internet connection – for the worst days of this latest New York drama, too.

But I survived, as did the system.

As did my dad, for a little while longer, for which I’m grateful.

Making a model out of a mountain of debt

I share all this to say that for me the financial crisis really was a one-off.

Not so for famed fund manager Ray Dalio, though. Roaming through history and across the globe, the billionaire says he has found similar events all over. And he’s gathered what he knows in a new book, Big Debt Crises.

Dalio explains:

After repeatedly being bit by events I never encountered before, I was driven to go beyond my own personal experiences to examine all the big economic and market movements in history, and to do that in a way that would make them virtual experiences—i.e., so that they would show up to me as though I was experiencing them in real time. That way I would have to place my market bets as if I only knew what happened up until that moment.

I did that by studying historical cases chronologically and in great detail, experiencing them day by day and month by month.

This gave me a much broader and deeper perspective than if I had limited my perspective to my own direct experiences.

Dalio has now collected and condensed this unusual research for the edification of all. Big Debt Crises is huge, and stuffed with diagrams and data. I admit I’ve only skimmed it so far. It seems cheap at c.£12 on Kindle.

However the even better news is you can currently download it as a PDF for free!

Go to Dalio’s website, and scroll down to the appropriate box to submit your email address. You’ll be signed up for marketing emails, but you can immediately unsubscribe after downloading the e-book if you want to.

Dalio claims the models that his firm Bridgewater created on the back of this research helped it do well in 2008 when so many floundered.

Forewarned is forearmed and all that, but I hope we don’t have to test the thesis again anytime too soon.

Where were you during the financial crisis ten years ago, and what were you thinking? It’d be interesting to hear some more personal (and I guess ideally not political) recollections in the comments below.

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Ready for a bun fight? Commercial property is a controversial asset class, even among passive investors.

Okay, we’re not talking the “Let’s take this outside!” fury of the gold bugs, or the evangelism of a Bitcoin absolutist.

But it’s surprising how much controversy an out-of-town office park with easy access to the M4 can inspire.

• Yea! Commercial property fans say it offers diversification away from shares, without giving up as much potential return as cash and bonds. Property gets its own allocation in several popular model portfolios.

• Nay! Detractors say the diversification benefits are not proven, that most of us already have exposure to property through other shares and even our own homes, and that the assets themselves – big buildings that are expensive and time-consuming to sell – are ill-suited to retail funds. Many model portfolios skip property altogether.

Who’s right? Let’s consider the pros and cons of commercial property and you can make up your own mind.

Characteristics of commercial property as an asset class

Academics place commercial property somewhere between shares and fixed income in terms of risk and return.

This makes sense if we think about the bricks and mortar reality of property.

While the specifics vary, a commercial property – an office, hotel, warehouse, or apartment block – is basically a building that is let to tenants. Out of these rents, the building usually pays its owner an income. This cash flow is roughly akin to the coupon you get with fixed interest such as a bond.

Think more a riskier corporate or high-yield bond than a government bond, though. The rent from a property is not guaranteed, and the future value of the property is not certain.

The sort of tenants you have may determine how confident you can be as a property owner that they’re going to pay you on time. You may even agree a lower rent with a higher quality tenant. Government bodies or blue chip firms on long leases are safer. Properties let to them are akin to better quality bonds.

Alternatively, you might gamble on risky tenants for a higher income. If they do default you can replace them, after some disruption – unless your property is in a worsening part of town or there’s some other reason why it’s become less desirable, such as rising crime or even a war (possible on a global view.)

Here your property looks more like a very high-yielding, riskier, corporate bond.

We should consider, too, the upkeep of property.

Buildings don’t repair themselves. If you own your own home, you already know property can be a money sink. It’s not just the maintenance and repair. There’s also the cost of keeping up with technological advances and fashion.

Walk around the oldest part of your town. There are no outdoor toilets. Central heating and mains plumping will be universal, even in 200-year old buildings, as will be insulation and glazing, lifts and escalators, communications cabling, and so on.

All those upgrades took money. Keeping your property modern and competitive is an ongoing business.

This is the more business-minded, equity-like aspect to property. Landlords spend to maintain or increase their properties’ value. Such outgoings are another claim on the cash flows coming from rent. What to best spend money on is a judgement call.

That’s very different to a bond. From the investor’s point of view, a bond just sits there paying out cash until it’s redeemed.1 It is a more straightforward investment.

On the other hand, compared to most equities, a property is a pretty stable asset. Many companies strive to reinvent themselves just to keep their customers. The property sector does change, but the pace is slower.

Property is also a real asset, like shares, gold, and ‘valuable stuff’ like antique chairs.

Real assets can increase in value with inflation, unlike paper assets such as banknotes or most bonds. The latter2 are redeemed at a pre-set face value, which means their spending power will be shrunk by inflation.

Boil it all down and you see property is a real asset that is a bit of a bond/share hybrid.

No surprise then that the risk versus return profile sits between shares and bonds.

Note that some listed property companies (including some REITs) do a lot of development work. This involves planning and building properties, and perhaps trying to let them out before selling them on. Where development makes up a significant portion of their business (as opposed to letting out finished buildings) I’d say such REITs should be thought of as even more like equities than bonds in terms of risks, rewards, and volatility.

You always need to look under the hood of any property investment, be it a passive fund or an actively managed trust, to see exactly what you’re getting.

An off-the-shelf property empire

I’ve gone into this granular level of discussing single buildings with leaky roofs and dodgy tenants to explain the fundamentals of the asset class.

Fear not – as private investors we won’t be haggling over factories or running office blocks ourselves.

Instead we pool our money into funds. This way we can own a bit of many buildings or developments.

Diversification across an asset class like this reduces the risks compared to buying your own entry-level commercial property, such as a newsagent or a commercial lock-up.

Property funds enable you to get exposure to the underlying asset class with a single purchase. Many pay out a fairly high income, too, reflecting the income-generating nature of most non-speculative3 property investment.

But funds come with their own difficulties, too. We’ll get into them in a follow-up post.

Returns from commercial property

So far I’ve described commercial property through my lens as an active investor.

I just can’t help thinking about how underlying businesses work!

But if I were my sensible passive investing co-blogger, I’d focus on property’s historical returns. There’d be nary a mention of leaky roofs or unreliable tenants.

You say, toe-may-toe, I say, tom-ah-toe – let’s do it his way before he calls the whole thing off.

The Financial Conduct Authority (FCA) recently published historical nominal4 returns for commercial property from 1990.

It also gave the return expectations that it was comfortable with pension funds and advisors using in their forecasts.

Quoting data from the Investment Property Databank, the FCA says:

• The average annual nominal total return from commercial property from 2001 to 2016 was 7.7%.

• The median annual nominal return was 9.9%.

These returns are at the property ownership level – that is, as if you owned the building yourself. They exclude the impact of development costs and transactions.

Now, huge pension funds and life insurers do own some property directly, as well as using funds.

But private investors like us will struggle to scrape together the money for a tower block in Docklands. We’re interested in the return from the property funds, ETFs, and listed company shares that we use to gain exposure. And you can be sure we will have to pay some costs.

To get closer to this, the FCA looks to the historical returns of the AREF/IPD UK Property Fund Index.5 The index includes:

“… the impact of development costs and transactions as well as the returns from other assets (such as cash and indirect property investments), the impact of leverage, fund-level management fees and other non-property outgoings.”

Costs reduce the return seen by private investors. On this basis, over that same 2001-2016 timescale, the AREF/IDP index has:

• The average yearly nominal total return for property at 6.3%.

• The median yearly nominal return at 9.4%.

Interestingly, the AREF data also goes further back, to 1990. Over this longer time period, which will dilute the impact of the financial crisis:

• The average and the median returns were 6.5% and 10.1%, respectively.

These returns came with huge volatility, especially during the financial crisis.

Look at the following graph:

Source: FCA/AREF/Datastream

If you owned property in 2007 to soften the impact of equity market falls, you might have asked for your money back.

An aside about income

That graph shows us another important characteristic of commercial property – in many years, income (the red portion of the bar) is a sizeable portion of the return you get from property.

The income component of the return is also far more stable than the feast and famine of capital gains.

Be sure to hold your property assets in a tax shelter such as an ISA or SIPP where possible, to avoid this income being scythed away by taxes.

Also note, the income paid out by a REIT looks like a dividend but most of it is technically a Property Income Distribution.6

This may present tax issues outside of tax shelters. See this handy explainer from British Land.

The REIT stuff

As we’ll see next time, many private investors get their property exposure by investing in a particular kind of investment trust called a REIT.7

The FCA gives nominal returns for the FTSE 350 index of these REITs as follows:

Source: FCA / Bloomberg

Total returns since 2005 look lousy – especially given the accompanying high volatility. (A downside of stock market-listed property funds is you get at least some of the volatility of shares but also the lower expected returns of property.)

It’s clear the financial crisis of 2007-2009 clobbered returns, as we also saw in the graph.

Over the shorter period since 2010, returns have been good. But half a dozen good years is a thin track record to hang your hat on, even if you believe the financial crisis was a once-a-generation event.

Some property skeptics such as Lars Kroijer argue that we simply don’t have enough long run data to justify investing in this asset class specifically8 – at least not as private investors.

To that point, the specific REIT structure has only been going in the UK for a little over a decade! (Previously what became the first REITs were more traditional property companies with a less attractive tax profile.)

You may retort that individuals have made famous fortunes wheeling and dealing in property directly. But this experience may not prove to be very analogous to owning a stock market-listed REIT in an ISA.

On the other hand, Tim Hale of Smarter Investing fame believes the (short-run) data is good enough to justify adding a global REIT to a passive portfolio.

After voicing reservations about traditional property funds that locked up investor money during the financial crisis9, Hale says:

“Holding a global REIT passive fund makes sense from a diversification perspective […]

Property tends to have a low correlation to equities, providing diversification benefit, as property performance is usually linked to rental value, in turn linked to economic growth, unlike the earnings of non-property companies that are less correlated to economic growth.

This is borne out in a correlation of 0.5 that is exhibited between UK equities and global property. This diversification is achieved without the substantial return give-up of holding bonds or cash.”

While I broadly agree, I’d caution that Hale’s correlation data does not seem hugely extensive. It’s unclear from his book, but as best I can tell it seems to be drawn from the 20-year period from the 1990 to around 2009.

Also, given that interest rates mostly fell throughout those years – eventually to near zero – I wouldn’t describe it as a wide range of environments to draw conclusions from.

I’m also unclear as to whether Hale has backed out currency swings when he compares a global REIT to UK equities.

Again, over such a short time frame, currency risk could be a meaningful contribution to relative returns.

Future returns from commercial property

Summing up, property valuations can be almost as volatile as equities, but the income is generally much more stable, giving us a mix of the characteristics of equities and bonds.

In addition, property itself tends to be illiquid, due to the expense of buying and selling.

This may or may not be the case for your chosen investment in the short-term10 but it stands to reason that long-term, property holders will probably get an additional return for putting up with this illiquidity with their risk capital.

What’s it all worth, in terms of expected returns? Finger in the air – probably a bit more than owning very liquid bonds, but a bit less than owning very volatile equities.

The FCA report agrees, and estimates an expected real return on property that’s somewhere between the expected returns from equities and from bonds:

We assume a spread over government bonds of 3% to 4%, over a 10-15 year time period.

This implies a real return on property of 2.5% to 3.5%, based on the midpoint of real government bond returns of -0.5% and nominal returns of 5% to 6% based on a GDP deflator assumption of 2.5%.

This expected return guidance from the FCA is lower than it recommended just a few years ago in 2012, incidentally.

The reduction follows a corresponding drop in its projected real returns from government bonds. As I’ve mentioned many times, you can’t just look at rock bottom government bond yields and presume everything else is that much more attractive – at least not if you believe in classical economy theory.

Government bond yields underpin expectations elsewhere; they are the ‘gravity’ of financial markets, as Warren Buffett puts it.

If forward returns from government bonds are low, then the market has its reasons (it fears recession, or doubts we’ll see inflation, for example). Those reasons will often affect what we can expect to see from other asset classes, too.

On the other hand, while expected returns are a key part of passive portfolio construction, I wouldn’t bet my life on them. Forecasting is fraught with difficulty.

Property, especially, seems to me an asset class in limbo. It’s been struck by a deep crisis within the past decade while also being boosted afterwards by ultra-cheap money.

In addition, the world’s property estates face a secular upheaval from the shift to online shopping, socializing, and business, which could permanently impair the demand for some property, or at least force more refurbishment and regeneration.

Don’t get me wrong, I think the asset class has its attractions – and UK REITs focused on London seem to me a potential bargain right now. But I’d suggest a modest allocation of about 5-10% is about right for most passive and active investors, given the risks, prices, and economic backdrop.

In a follow up article I’ll look at how you can buy into property without dealing with a single suited geezer or donning a hard hat. Subscribe to make sure you get it!

1. A professional bond investor will look into the viability of the company or government behind the bond. But the actual security itself is just an IOU with a known income attached. [↩]
2. That is, not inflation-linked bonds [↩]
3. i.e. Development. [↩]
4. That is, without adjusting for inflation. [↩]
5. This is based on the performance of members of the UK Association of Real Estate Funds (AREF) and published by IDP. [↩]
6. In short, the letting income is paid out as a PID, whereas money made from other activities can be paid out as a dividend. [↩]
7. Real Estate Investment Trust. [↩]
8. Global index funds as favoured by Lars will include a small percentage of property companies. [↩]
9. Some also did this again after the Brexit vote correction. [↩]
10. A REIT can be sold at any time, but potentially at a discount to underlying value, a non-listed fund may be ‘gated’, locking up your capital, which stops panic selling but is no good if you need the money. [↩]

What caught my eye this week.

There are some things you have to experience to fully understand. Losing your virginity is famously touted as one. Parents say bringing up a child is another. I haven’t had that pleasure and I am more than happy to take their word for it.

One I would add to the list though is reaching what I suppose we must call ‘middle age’ (excuse me while I pop off to shout into a pillow… okay, back now, that’s better) and looking back at the various ways your life to-date has fallen short of what might have been.

Sometimes you didn’t realize why at the time. Perhaps you were being paid a fair whack not to think about it. Occasionally you were having a blast. Sometimes you had an inkling. Sometimes you couldn’t pay the rent so it was pretty obvious.

Maybe the Japanese explain it best with this phrase and associated image, as shared by Rachel page on Twitter:

Looking at this diagram, I feel like I’ve lurked in the outer suburbs for most of my life, like some frustrated Home Counties adolescent poet – certainly not on the isolated fringes, so comfortable enough, but never in the thick of everything and completely fulfilled.

If I have achieved Ikigai then it was only fleetingly, and I’m not sure I noticed in the moment.

Many seekers after financial freedom, such as my co-blogger, don’t seem to believe they can ever achieve Ikigai through work, so they best opt-out ASAP. I’ve said many times I believe there’s a risk of swapping one dissatisfaction for another by bailing out entirely – not to mention the pain of getting there – but plenty disagree.

I like this diagram because it suggests a wonderful balance is possible. But I’d agree that like a Zen koan it’s probably more something to be than achieved by most of us.

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