Many property owners are currently concerned with the impact of the COVID-19 pandemic on the value of their property. We are currently being showered with news from all sides explaining the impact of coronavirus on the global economy. Sometimes dramatic doom scenarios are drawn. But what is it about the reports? And how badly are properties actually affected? In this article I would like to show from the perspective of a capital market scientist what the effects on the real estate market have been so far and what can be done to reduce your risk in the future.
1 What is the impact of Corona on the value of real estate?
First of all, I want to go into how the corona crisis affected global equity markets. This is to help us put the economic impact in a historical context. Because the daily reports often sound more dramatic than the condition actually is. I will then explain how you can visualize the performance of real estate and compare stocks and real estate.
1.1 How is the stock market affected?
From February 20, due to the increasing spread of the corona virus, the stock markets began to respond to the pandemic with negative returns. As a result, global equity markets fell about a third (23%) by March 32. Then they recovered by more than half, so that we stood at -7% on May 16th (MSCI ACWI).
As can be seen from the following stock market developments, the impact on the stock market is relatively small compared to the technology stock crash in the years 2000 to 2002 and the financial market crisis from mid-2007 to 2010. The stock market should have dropped a third again to have the effects at the same level as in the last two major crises. We tend to feel the strong economic effects in everyday life. This observation contrasts with the last financial market crisis, where the economic effects were felt more on the stock market than in everyday economic life.
Source: MSCI All Country World Index, including dividends, converted to euros, January 1988 to April 2020
The very strong price losses are also not unusual. Similar strong price losses occur regularly and were, for example, in August 1998 with -14,8% stronger than in March 2020 with -13,4%. Even on individual days, they occur regularly in the order of magnitude that has recently occurred.
The impairment comes about because investors expect lower returns. From an investor's perspective, the value of a share or property corresponds to the value of future profits. However, since the profits are in the future, they must be discounted to determine today's value. At an interest rate of 1% pa, € 100 that you only get in one year is worth only € 99,01 today. If the risk increases and future profits become uncertain, then the interest rate at which future profits are discounted must also increase. With an interest rate of 5% pa then € 100, which you only get in one year, is worth only € 95,24 today. The value of a share therefore corresponds to the sum of all future discounted profits.
So we are still a long way from a collapse of the EU monetary system and doomsday scenarios, as are repeatedly evoked by German stock market gurus.
1.2 How is the real estate market affected?
One of the questions that drives investors time and again is what risk is associated with an investment in real estate. The answer to this question is simple in the stock market. You only have to search for a single share or a stock market index, such as the DAX or MSCI World, and you get the performance as well as various risk indicators. For shares, these are based on market prices - i.e. on trading prices from daily transactions that are carried out and recorded on the stock exchange. These prices are the prices at which the shares can actually be bought or sold.
Unfortunately, this is not possible with real estate. On the one hand, every property is unique, on the other hand, individual properties are not traded on a daily basis. Years or decades often pass between buying and selling. So there are no daily market prices that represent the performance of a single property. This lack of data means that no well-founded risk measurement is possible.
1.2.1 Economic forecasts
The Cologne Institute for Economic Research (IW) recently published an economic opinion on the price effects on the housing market due to the Covid 19 pandemic. In it, the authors write that it is decisive for the current price effects whether the price level before the crisis was excessive or appropriately valued. A real estate bubble like in the last financial crisis can be recognized by a rapidly increasing construction activity, is often accompanied by excessive lending and has falling costs for owner-occupiers and tenants. None of these three signs was visible in Germany (Colonel and Voigtländer 2020).
Economists at the Empirica analysis company expect a “dent” in the coming months, which should be between -10% and -25% (Braun and Simons 2020). The IW economists, on the other hand, use interest rate scenarios to estimate that German property prices will fall between 2,8% and 17,4%. According to the IW, interest rate changes are expected to have a significant impact on property prices. In the worst scenario, real estate in big cities is less (Colonel and Voigtländer 2020). However, this forecast misses reality. If we look at historical returns from real estate funds and the level of interest rates in the United States from 1979 to 2014, there is hardly any connection. It is therefore hardly possible to draw conclusions about the performance of real estate from the development of interest rates. Especially since the forecast of interest rates is already difficult enough (Rodriguez 2015). There is also no reason to assume that this connection could occur in Germany. Such forecasts are therefore not very suitable for justifying investment decisions. They are based on assumptions, estimated values, data crutches such as evaluations by experts and are therefore not reliable.
1.2.2 Real estate indices
Risk measurement using real estate indices is very popular in the real estate industry, but it is extremely problematic. There are hardly any suitable indices that can show us the price development of the past few weeks. Kommer and Schweizer also list the following four reasons against real estate indices (Kommer and Schweizer 2018):
- Real estate indices are often based on appraisal assessments or other estimates from banks, for example, for loan applications.
- In real estate indices based on offer prices, there are smoothing tendencies that dampen the fluctuation in value up and down (Geltner 1991).
- Real estate indices do not include any transaction costs, which differ immensely from securities.
- Real estate indices are broadly diversified and represent the real estate market, whereas real estate investments are typically made in one or only a few individual properties. However, a single property has a high unsystematic risk, which is eliminated in a market index through diversification.
1.2.3 Real estate funds
However, there is a method of risk measurement that has long been established in capital market research (Kommer and Schweizer 2018, Rodriguez 2015). To do this, you use securities that represent the asset classes or the real estate market. Real estate funds or real estate investment trusts (REITs) are used for this, with which one can determine the risk of real estate investments very precisely. Although REITs only represent a small part of the real estate market, they reliably reflect its value development (Rodriguez 2015).
A REIT is a company that invests in many different properties. Examples include Vonovia and Deutsche Wohnen, which are also included in the indices used below as the largest German REITs. A real estate fund index in turn summarizes the performance of many REITs.
The following illustration shows that global real estate funds (FTSE Nareit All Equity REITs Index), global stocks (MSCI ACWI), German real estate funds (FTSE EPRA / NAREIT Germany Index) and German stocks (DAX) have been trading in the last few weeks since February 20 developed similarly. The prices of real estate funds initially fell by approx. 35% and then rose again for German real estate funds to approx. -20% and for global real estate funds to approx. -15%.
However, it must be noted that the performance of REITs reflects the performance of real estate in a leveraged form, as the latter are usually financed with outside capital. The real estate is financed with loans, whereas real estate companies have an average debt ratio of 25% to 50% (Kommer und Schweizer 2018). The returns and fluctuations in value of REITs are therefore greater than those of real estate. However, it can be concluded from the performance of REITs that property prices initially fell and then rose again somewhat.
A simplified calculation allows the following statement to be made about the real estate market: Since the value of REITs initially fell by around 35% and then returned to a level of around -20%, an assumed debt ratio of 50% would result in the real estate market initially fell about 17,5% and then returned to a level of around -10% in Germany. Assuming a debt ratio of 25%, it would appear that the real estate market initially fell by around 26% and then returned to a level of around -15% in Germany. Note that this is just a simplified calculation that brings with it various problems. As already shown, the calculation depends significantly on the external financing ratio, but also, for example, on the cost of capital or the interest rate on the real estate loans.
1.3 How badly are individual properties affected?
It is difficult to determine how much the value of an individual property was influenced by Corona. Every property is unique and therefore has its own performance. It is important to note that even a single property is subject to fluctuations in value, even if it does not have a price tag that changes daily. Just because the risk cannot be seen directly does not mean that there is none.
Since Nobel Prize winner Harry Markowitz has shown with modern portfolio theory based on stocks that diversification reduces risk (Markowitz 1952), we have known that a single property is affected on average with a greater fluctuation in value than the entire property market. By spreading the risk across various properties, unsystematic risks are diversified away and the investor only bears the systematic market risk.
You can also derive further trends in detail. Real estate with a commercial tenant who slips into bankruptcy due to the economic consequences of Corona and is no longer able to carry out the agreed dismantling is certainly more impaired in value than real estate rented by a doctor who can continue to work as usual.
2 What options are there to reduce the risk?
It is difficult to reduce the risk in the portfolio. To do this, you would first have to sell real estate. However, there are a few simple ways to keep the risk of future investments as low as possible. Diversification reduces risk. Everyone knows this simple principle, but hardly anyone implements it. If you diversify as much as possible, the principle applies: risk and return are inseparable. Nobel laureate William Sharp has shown the connection between risk and return using the Capital Asset Pricing Model (Sharpe 1964). A lower risk therefore leads to a lower return expectation. Below I would like to give you some thoughts on how to diversify better.
2.1 Several individual properties
It certainly makes more sense to buy several small properties than one large property. Even if this goes hand in hand with higher transaction costs and higher administrative expenses. However, it makes little sense to put all of your assets in a single property. Often the majority is then financed by a loan.
How many properties are necessary for the sufficient diversification of the risk cannot be said exactly. In science, it is said that with perfectly selected stocks, a number of 10-30 individual stocks diversify away most of the unsystematic risk. Due to a lack of data, it is impossible to say whether this is also the case with real estate. In any case, they would have to be as different as possible, i.e. in different regions, ideally distributed globally and used differently, i.e. as an apartment or commercial rental space. But the rule of thumb applies, the more the better.
However, sufficient diversification with individual properties will not be possible for most investors. Most people simply don't have enough money to do this. For ten very cheap apartments of € 100.000 each, you would need € 1.000.000 capital or, with 50% debt financing, € 500.000 equity. The diversification with ten properties would still be at a fairly low level. But there are also alternatives.
2.2 Diversification with real estate companies
The purchase of shares in a real estate company or REIT does not buy a single property, but a share or a fund share. This indirectly acquires a large number of properties. According to the company's own information, for example, the largest German publicly tradable real estate company Deutsche Annington Immobilien Gruppe currently over 416.000 individual apartments, followed by German living with 165.000 units.
It is often argued that an investment in real estate companies is equivalent to an investment in small stock corporations (small caps). However, this is not the case, even if real estate in crises is often affected to the same extent as small caps. Looking at the historical performance of REITs, this is only 55% the same as that of small caps. Real estate must therefore be seen as a separate asset class (Rodriguez 2015).
2.3 Diversification with REIT ETFs
You can spread the risk further by not just buying a single REIT, but all of them. REITs are summarized in indices such as the FTSE EPRA Nareit Global. In turn, you can invest in this index using an ETF. Rodriguez estimates that REIT indexes can be used to map over 50.000 properties with multiple units each worldwide (Rodriguez 2015).
This type of system has several advantages:
- It is almost maximally diversified in the real estate asset class.
- The transaction costs are usually well below 1% compared to approx. 10% when buying a single property.
- Administration is minimal.
- With an additional investment, there is no higher administrative effort.
- The actual value is available daily as price information.
- The system can be sold at a fair price at any time.
2.4 Other asset classes
If you want to position yourself professionally in the long term, you should also consider other asset classes. These are essentially stocks, bonds and commodities. For most investors with an average risk appetite, a simple portfolio consisting of an ETF that tracks the MSCI All Country World Index and another ETF that tracks bonds with a short term and a high credit rating can be very useful.
However, investors should not do without the help of a good investment advisor. This brings an average added value of approximately 3% pa. It can help in particular with cost-effective and tax-optimized implementation and avoid expensive behavior errors (Vanguard 2015).
2.5 Diversification in comparison
The table below is intended to illustrate the benefits of diversification. For this purpose, the largest US apartment rental company was chosen in order to have the longest possible observation period. German real estate companies have not been traded on the stock exchange for so long that data up to 1995 are available accordingly. The housing company is compared to the local housing companies' stock index and a general stock index. The standard deviation, i.e. the average fluctuation in value, decreases with additional diversification. The biggest drop in the course is also significantly reduced.
Risk ratios of different listed investments and indices in US residential real estate - period 1995 to 2017 (23 years)
|AvalonBay Communities, Inc.||FTSE NAREIT USA Residential REITs Index||MSCI USA SMID|
|Type of investment||Share housing companies||Stock index housing companies||General stock index|
|Standard deviation of annual returns||30%||19%||19%|
|Maximum cumulative loss||–69%||–68%||–54%|
Source: (Kommer and Schweizer 2018)
The stock market has not developed as badly as it is partly conveyed by the media. The effects are nevertheless not negligible. The real estate market is affected similarly. Real estate companies fell 35%, but have already recovered somewhat. The loss in value of an individual property must therefore have been between 17% and 27%, and has now been reduced to 10 to 15%. Individual properties are more affected.
Therefore, investors should fundamentally diversify as broadly as possible and take REIT ETFs or a globally diversified equity portfolio seriously. An investment adviser can create great added value.
About the author
Nicolas Stelter develops visions for their lives with his customers and then shows them ways in which they can be implemented. As an investment advisor, he supports you with strategic financial planning, scientifically sound investment strategies and coordination of all financial matters.
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