Play at the margins, AustraliaNovember 22, 2017 / By
“The First Law of Economics: For every economist, there exists an equal and opposite economist.”
So the joke goes about economists being unable to form agreement. But (by definition) one thing we can all agree on, economists included, is that all cycles must come to an end – a clearly important notion in the current Australian (and global) commercial property landscape. Another concept in which economists also find agreement in is that pricing and values are set at the margin. And at the core of this concept is the marginal buyer.
Simply put, the marginal buyer is the person/investor willing to pay the most for a good or service. This basic concept is not something that most of us explicitly pay attention to, but we should. Why? Because the marginal buyer not only dictates pricing and values, but also the stability and volatility of a market.
In real estate, the role of the marginal buyer arguably takes on greater importance towards the end of cycles. In the early stages of rising markets, valuation metrics improve, income rises, capital values increase, and total market capitalisation grows, all with minimal risks to the market and broader economy. All upside for investors, developers, and financiers.
But what happens at the other end of the real estate cycle spectrum, when investors, developers, and financiers start to speak about “bubbles”? What happens when valuation benchmarks start to surpass previous peaks? And what happens when cap rates begin to trend below previously assumed cap rate floors to new record lows, as we’ve seen in Australia?
Well, if that marginal buyer deems that pricing has exceeded fair value and no longer participates in the buying of real estate, then the current strength in capital markets is likely to stall, especially if there is a disconnect between buyer and vendor expectations. The marginal buyer is thus a good indicator of when downside risks are no longer just academic ‘what ifs’ but become market realities.
But while it’s important to analyse the marginal buyer, particularly when cycles turn, it’s equally prudent to examine marginal value for upside risks. In real estate, we can enhance marginal value in a number of ways:
- Increase portfolio valuations – Active asset management, improving tenancy mix, maximising and diversifying income streams, and capital expenditure works.
- Maximise investment capital – Counter cyclical strategic acquisitions (eg: Brisbane and Perth CBD office, Adelaide industrial), portfolio diversification (eg: Canberra office vs. other CBD office markets – low total return correlation)), and alternative sector investments (eg: infrastructure, student housing, agriculture, etc).
- Reduce the weighted average cost of capital – Diversify capital sources/seek alternative sources of capital, and optimise gearing levels.
So, in order to both analyse risk and identify opportunities, we must look to the margins. And it’s at the margins, particularly at this stage of the cycle when you can no longer rely upon the rising tide, where you can find yourself on either the right side or wrong side of the “First Law of Economics”.
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