Super-prime’s invisible driver

After more than a year of outperformance, bubble talk is beginning to stalk the super-prime market and I, like many others, have been gripped by the conversation taking place.

Can the disproportionately high prices achieved in places like London be sustained? Or are we on the verge of another stellar property correction?

To make the right call it’s important to understand what’s really driving the outperformance. The most common explanation by far has been to blame hot money from overseas. Foreign buyers may be cash-rich, but that fact is hardly new. Something else has changed in the market which, I would argue, could indicate that super-prime is undervalued.

In 2008 something extraordinary happened to the market’s structure.

Rather than allowing defaults to crumble the system, major governments and central banks stepped in to provide bids where none existed – regardless of whether or not deteriorating returns and cash flows were to be expected.

In some cases they did so directly, by buying up mortgage securities; other times they did so more implicitly, by flooding the system’s financial institutions with liquidity.

Whichever way they went about it the result was the same: a proverbial line was drawn in the valuation of distressed assets and real estate, beyond which prices simply could not fall. Central banks had, of course, hoped to stimulate risk appetite. However the outcome was more akin to a giant game of rich people’s musical chairs, with one chair in a much better position than the others, in a world where everyone suddenly gets a seat. The only way to maintain the hierarchy is to overpay for what you consider to be the best seat.

The consequence is that an ever larger swath of global property is potentially being overvalued. And while prices may fluctuate regionally, it’s becoming ever less likely that the market can collapse while invisible governments’ hands support it.

What has that got to do with the super-prime sector’s outperformance? For one thing, it’s clear that part of the market is betting that if and when prices do fall, they’ll do so because state aid has finally been removed. I don’t see that happening any time soon. But it’s also betting that if they do fall, they’ll do so in tandem, meaning no one – apart from the most indebted who are suffering negative equity – would likely be relatively worse-off in material terms.

More important is the fact that in today’s property market there’s increasingly everything to gain and nothing to lose. After all, what’s the worst-case scenario? As far as I can see, it is that an ever greater share of the market will end up owing the government rather than a bank.

The same level of certainty cannot, however, be applied to alternative “store of value” assets. Take the conventional safe haven of government debt. Nowadays, you’re either exposed to capital destruction on account of sovereign risk, as per Greece and other eurozone periphery debt, or fighting the crowd for a chunk of, say, German debt.

Given that investors are even imposing negative rates on each other, a new investor prerogative focused entirely on dodging savings decay now comes to the fore.

Money not spent or invested depreciates over time. Compound interest is a thing of the past. Hence the sudden imperative to spend on anything that’s positive-yielding, durable and legally secure. Super-prime property satisfies on all those fronts, and it provides a high enough valuation to make it a real alternative to the safe haven bond trade. But there’s more to it than just that.

More cynical minds might suggest that what we’re really struggling with is how to put a price on private property rights in a de facto nationalised market.

In that case, what the super-prime sector’s outperformance may represent is a transfiguration of sorts. It’s not real estate that’s being priced on the basis of location, utility and rent any more. It’s the safety associated with owning solid private property rights when contractual terms all over the investment world are becoming ever more uncertain.

In several ways super-prime now represents the last refuge of the affluent. When you consider that, it’s easy to understand why super-prime property, when compared with the rest of the market, might still look undervalued to many.

The trade is not about absolutes but relativity, and most of all about avoiding negative yields at the bank.

Money can no longer be deployed productively very easily.

To overpay for real estate at least secures you relative value, a positive yield and a perch above Hyde Park. Overpaying for a bond at auction, on the other hand, loses you value from the onset while securing little but a negative-yielding piece of paper.

Izabella Kaminska is an FT Alphaville reporter

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