Causa remota of any crisis is the expansion of credit and speculation while causa proxima is some incident that saps the confidence of the system and induces investors to sell commodities, stocks, real estate, bills of exchange, or promissory notes and increase their money holdings. The causa proxima may be trivial: a bankruptcy, a suicide, a flight, a revelation of fraud, a refusal of credit to some borrowers, or some change of view that leads a market participant with a large position to sell. Prices fall. Expectations are reversed. The downward price movement accelerates. To the extent that investors have used borrowed money to finance their purchases of stocks and real estate the decline in prices is likely to lead to calls for more margin or cash and to further liquidation of stocks or real estate. As prices fall further, bank loan losses increase and one or more mercantile houses, banks, discount houses, or brokerages fail. The credit system appears shaky, and there is a race for liquidity—Charles P. Kindleberger and Robert Z. Aliber
In this issue
Global Real Estate Services Cautions on Rising Office Vacancies, Top 5 Philippine Property Developers: Mounting Signs of Liquidity Crunch
I. Global Real Estate Services Cautions on Rising Office Vacancies and Depressed Rents: Blames Hybrid Remote Work and Global Markets
II. Q3 Real Estate GDP Buoyed by Sales Transactions as Rents Stagnated
III. Update on Real Estate Malinvestments: Rising Leverage Amidst a Downtrend in the Sector’s Share of GDP
IV. The Seen: Top 5 Property Developers: Tepid Revenue Growth, Margin Fueled Net Income BOOM!
V. The UNSEEN: Top 5 Property Firms: 9M Cash Reserves Plunged, Debt and Interest Expense Zoom to Historic Highs!
VI. Property Industry’s Demand for Rent: Follow the Money and the Slowing Revenue Growth of Retail and Food Chains
VII. Q3 & 9Ms Financial Performance of the Property Index; REIT Did Better than their Parents
VIII. Mainstream’s Addiction to Inflationism, Real Estate Bubble Equals the "Fictitious Wealth."
Global Real Estate Services Cautions on Rising Office Vacancies, Top 5 Philippine Property Developers: Mounting Signs of Liquidity Crunch
The weakest link of the Philippine real estate bubble has been office spaces. However, the financial performance of the top 5 developers showed that this has spread.
I. Global Real Estate Services Cautions on Rising Office Vacancies and Depressed Rents: Blames Hybrid Remote Work and Global Markets
Different surveys generate different results.
First, elevated office vacancy rates have capped rent increases, a global real estate services firm recently reported. (all bold mine)
Businessworld, November 16: In a statement on Wednesday, Cushman & Wakefield said office vacancies in Metro Manila rose by 72 basis points (bps) to 16.83% by the end of the July-to-September period from 16.12% in third quarter a year ago. It noted the office market is in a “slow recovery” as remote work schemes remain prevalent among local information technology and business process management (IT-BPM) companies. Quarter on quarter, the Metro Manila office vacancy rate was down 6 bps from 16.9% in the second quarter…Amid the high vacancy rates, landlords have delayed rent increases. Ms. Castro noted average asking rents to have only gone up by 0.15% year on year to P1,042.17 per sq.m. per month as of the end of the third quarter…Claro dG. Cordero, Jr., Cushman and Wakefield director and head of research said, vacancy rates are expected to remain high. “The current structural shift in office space occupation sweeping the global market has also been manifested (despite the relatively higher return-to-office ratio) in the local market, particularly in major CBDs (central business districts). Elevated vacancy rates are likely to persist, as global corporate occupiers brace for hybrid work arrangements and a new legislation is underway that will allow local IT-BPM companies to implement remote work schemes,” he said.
For them, these vacancies were about shifting work preferences (hybrid/remote). Embedded in it was an appeal to popularity: it's a global trend!
But there's more. Other factors may be behind these, too.
Mr. Cordero noted that elevated inflation and high interest, along with geopolitical conflicts, may create more market jitters and dampen the market’s recovery. “Lingering prospects of slower economic growth and the high-interest rate environment challenge the expansion of the Philippine REIT (real estate investment trust) market. The onset of a hybrid work scheme, early exit of POGO companies, and ongoing office space rationalization of corporate occupiers generally weigh on expectations of the future growth of office space demand,” he added.
In a nutshell, aside from hybrid work, inflation, high rates, lower economic growth, the exit of POGOs, and cost-cutting measures were also factors.
Figure 1
Sure, elevated office vacancies signify a worldwide phenomenon post-pandemic. (Figure 1, topmost chart)
But office and commercial real estate vacancies existed before this material shift in consumer demand.
The changing consumer preferences only exposed the unstated portion of the commentary: oversupply or malinvestments.
Put differently, vacancies represent excess inventories. Such excesses wouldn't have emerged had supplies been controlled or limited.
Importantly, it is a domestic dilemma. Global dynamics only reveal that local developers embraced the perspective that the demand for office spaces was linear.
That's right. Such excesses represent an error in their business models.
Yet, why have developer-entrepreneurs not forecasted and acted on this? Why the cluster of entrepreneurial errors that have led to such excesses? And why have incumbent developers been adamantly asserting that demand will recover in the face of the critical shifts in consumer preferences?
II. Q3 Real Estate GDP Buoyed by Sales Transactions as Rents Stagnated
Before continuing, let us shift to the other survey, the Q3 GDP.
According to the Q3 government national account data, real estate was one of the few industries that resisted the general downturn, which had deficit spending as its engine, as earlier explained.
But the sector's activities diverged. Real estate and ownership of dwellings are its two components.
"Real" real estate GDP jumped from 3.7% to 6.2%, the highest since Q4 2022, while "real" "ownership of dwelling" GDP remained stagnant for four straight quarters with a 2.1% GDP. The data extrapolates to activities related to buying and selling properties that boosted its GDP, while rental activities had been static for several quarters. (Figure 1, middle graph)
Yet, the industry posted a 4.2% GDP, the highest quarterly growth this year.
As it is, because the property sector outperformed the others, its share of the national pie rebounded to 5.9%, the highest since Q3 2022 of 6%.
In any event, its "outperformance" came amidst a stalling private sector economy, which hardly qualifies as creating more "value added."
III. Update on Real Estate Malinvestments: Rising Leverage Amidst a Downtrend in the Sector’s Share of GDP
Of course, as repeatedly stated here, despite its falling share of the GDP, the property sector's share of banking loans remains in an uptrend. (Figure 1, lowest chart)
More than anything else, there is a disproportionate distribution in bank financing and the GDP: the sector's share of universal commercial bank loans represented 20% even as its GDP share was only 5.9% (Q3).
Further, the downtrend in the GDP share and the uptrend in the bank loans reveal the impact of diminishing returns of the sector’s leveraged-driven GDP.
A back-of-the-napkin calculation shows that the sector uses a 3.39% share of bank (lending) resources to generate 1 GDP. Or, to produce more GDP requires even more leveraging!
To cut a long story short, the divergence view of the private sector survey could imply that the real estate GDP may have puffed up the actual contributions of the sector.
What's more. The public has turned the real estate sector into a casino backed by rapid trade churning in the hope of making a quick buck. This dynamic comes as vacancy rates in the commercial sector remain elevated.
So many gambled as risks continued to escalate.
But the real estate sector is interconnected.
There has been little realization that the industry has invested primarily in the foundation of the so-called "integrated community structure," anchored on urbanization and its extension of "satellite communities."
Yet, the dynamic preference of consumers became one of the challenges of this model.
And so, influenced by digitalization and pandemic policies, the transformation to hybrid/remote work has rendered a massive "sunk cost" or capital decumulation—signified by oversupply.
Of course, the predicament of the expert assumes a perspective based on the present rates of GDP.
The thing is, though office spaces are the concern here, all other segments of the property sector constitute part of such "integrated communities," which therefore extrapolates to interconnection.
By extension, it also means that the paradigm of "integrated community" is codependent not only on the vibrancy of the office properties but also residential, shopping malls, hotels, logistics and commercial hubs, and other related structures. (Prudent Investor, May 2023)
IV. The Seen: Top 5 Property Developers: Tepid Revenue Growth, Margin Fueled Net Income BOOM!
The florid 3Q news headlines may have overstated the financial performance of the listed top 5 developers. Sure, net income supposedly boomed, but it came amidst a mixed performance of their revenues and other financial aspects.
That is to say, reading between the lines is a sine qua non for any prudent investors.
After all, revenues, a component of aggregate spending, should resonate with the current or nominal GDP.
We shall harmonize the macro picture with the micro developments using the financial performance of the nation's listed top 5 (TOP 5) property developers.
Figure 2
The aggregate revenues of the top 5 (TOP 5) listed developers (SMPH, ALI, MEG, RLC, and VLL) jumped from 8.42% in Q2 to 14.03% in Q3 as real estate revenues grew from -2.5% to 10.7% over the same period. (Figure 2, topmost graph)
However, the total and real estate nominal revenues remain distant, -12.9% and -24.6%, from the pre-pandemic Q4 2019 record levels, respectively.
Nota Bene: Since Ayala Land's topline bundled sales and rent revenues, we incorporated it with real estate revenues—likely overstating the total.
Nevertheless, despite the aberrant pop in Q4 2020, the corroding share of real estate to total revenues reached its 2nd lowest level in Q3 2023, which indicates that property firms have become dependent on rent for their core revenues. (Figure 2, middle graph)
From here, retail conditions become a principal factor in establishing rent and total revenues.
A second important point: the share of the top 5's aggregate revenues to the sector's NGDP in 2020-2021 has barely recovered from the plunge in 2020-2021. The sector seems to be an outlier in the context of the deepening concentration trend in the economy. That is conditional on the accuracy of the estimated data.
The revenue-to-NGDP share declined from 30.9 to 28.8. However, NGDP has outsprinted the total revenues in Q3 of the top 5 developers. (Figure 2, lowest chart)
It reveals a wide dispersion in the supply component as mom-and-pop entities may have joined the speculative leveraged shindig of the build, sell, or rent model. Developments in my neighborhood could be a testament to this dynamic.
Figure 3
Circumstantial evidence shows that the sharp contraction of construction permits for single houses and apartments by 19.6% and 42.2% in Q3 2023 may be in response to rising vacancies amidst higher rates and a slowing economy. (Figure 3, topmost chart)
Since the Q3 2022 peak, construction permits for these sectors have declined.
Construction activities (via permits) of single houses and apartments could be the best representation of the participation of the mom-and-pop segment in the real estate bash.
In any case, widening margins of the TOP 5 have delivered the headline net income boom. Gyrations of the core inflation have correlated with margins.
The average total margins raced to an unparalleled height of 42% in Q3. As such, net income ballooned by 37.4% to Php 29.27 billion, 9.7% shy of the Q4 2019 record Php 32.41 billion. (Figure 3, middle and lowest window)
These represent the "seen" part as published in social media headlines.
V. The UNSEEN: Top 5 Property Firms: 9M Cash Reserves Plunged, Debt and Interest Expense Zoom to Historic Highs!
But here is the "unseen."
First, if the property firms have been raking a fortune from margins—which oddly benefited from inflation—why have their cash positions plunged?
Figure 4
TOP 5 cash reserves plummeted 34.8% in Q3 2023 YoY and have contracted during the last four quarters. (Figure 4, topmost chart)
Cash reserves hit an all-time high in Q1 2021, but the ensuing downtrend has led it to erase its recent gains. In Q3 2023, it plumbed to Q2 2020 lows!
Next, why have the same firms been on a borrowing spree? In Q3, aggregate borrowings of Php 952 billion and interest expenses of Php 11.04 billion have reached historic highs! (Figure 4, middle window)
Here is the thing. In Q3, net debt increased by Php 35.97 billion. On the other hand, the total Net income was Php 29.267 billion. Or, marginal income was higher by Php 7.927 billion YoY from last year's Php 21.295 billion. (Figure 4, lowest diagram0
No matter how one twists the angle, debt grew faster than income. From a net margin perspective, the top 5 RE firms borrowed 4.51 pesos for every peso income they generated. Incredible. That's if the reported income is accurate at all.
That's not all.
Despite the BSP rate hikes, interest expenses—though at unprecedented levels—remain subdued, which most likely represents debt contracted before the rate increases.
If rates remain elevated for longer, rolling over these liabilities should translate to substantial increases in refinancing costs.
This mounting mismatch—debt growing faster than net income—explains the deterioration of liquidity. Aside from increasing debt levels, RE firms drew from their cash reserves to finance internal spending and debt repayments.
The data and its extrapolation corroborate the cautious outlook of the global real estate services firm quoted above.
VI. Property Industry’s Demand for Rent: Follow the Money and the Slowing Revenue Growth of Retail and Food Chains
As noted above, because rent has transformed into the anchor of the revenues of the TOP 5 property firms, aside from financing, the health of the retail sector becomes the most crucial factor in forecasting the property sector's prospects and risks.
Figure 5
First, there is a close correlation between rent revenues and universal commercial bank lending conditions. Since peaking in Q3 2022 at 13.54%, bank lending growth has halved to 6.65% in Q3 2023. Rental growth of the top 4 (excluding ALI) culminated in Q3 2022 at 67.34% and has slowed to 14.8% in Q3 2023. (Figure 5, upper graph)
Second, the frenzied increase in household borrowings coincided with nominal rent revenue growth. (Figure 5, lower chart)
In short, bank lending has financed demand for rent.
Third, the credit boom has created the illusion of "sustainable" consumer spending, which prompted the "race to build supply" response.
Figure 6
However, the moderating bank lending growth has led to slowing revenue for the six biggest (non-construction) retail chains: namely, SM Retail, Puregold, Robinsons Retail, Metro Retail, SSI Groups, and Philippine Seven. (Figure 6, upper graph)
Since the Q2 2022 pinnacle of 28.6%, revenue growth has slid to 8.27% in Q3 2023 but was up from 6.5% in Q2.
It isn't a coincidence that the oscillation of percentage change has been synchronous.
There has also been a tight correlation between revenues of the four biggest food chains—Jollibee, McDonald's, Shakeys, and Max's—and the TOP 5's rent revenues. (Figure 6, lower chart)
However, growth YoY trends appear symmetrical with TOP 5's rent, as the aggregate revenue growth of Food chains culminated in Q3 2022 at 50.9%, then slowed to 12.9% in Q3 2023.
As a caveat, much of the splendid % growth represents a function of base effects—or comparing a normalized economy with the transition from partially opened post-pandemic conditions.
Human activities are interconnected. Feedback loops constitute a process and diffuse into a broader segment of the economy over time.
For instance, slowing consumer spending (due to inflation, too much leverage, decreases in passive income, etc.) leads to lower retail revenues (eventually income), which reduces demand for commercial rent. Stagnant investments or cost rationalizations could lead to reduced profits (or even losses) that could diminish demand for other real estate products, such as office, retail, factory, storage, logistics, and warehouse spaces.
This pressure build-up may also spread to other business edifices such as the MICE (meetings, incentives, conferences, and exhibitions) as well as luxury establishments like accommodations (hotels, resorts, etc.), sports clubs, galleries, and more. Adjustment to structural malinvestments (sunk costs) will also lead to disemployment, which should expose the surpluses among residential spaces and other institutional structures (schools, health clinics, hospitals, etc.)
Office vacancies represent the weakest industry link. However, as demonstrated above, stress has been building throughout the industry. Thus, fragility should spread from "satellite enclaves" to the "integrated structural communities" or from the periphery to the core.
For want of doubt, unless credit conditions improve or unless productivity gains take over (ideally), the financial and liquidity challenges of the industry, as showcased by the TOP 5, will likely see further corrosion.
To this end, solvency issues among many heavily leveraged property firms should emerge, affecting the balance sheets of banks, which should escalate strains on systemic liquidity. The ensuing feedback loops raise the risks of economic recession, and worst, a financial crisis.
VII. Q3 & 9Ms Financial Performance of the Property Index; REIT Did Better than their Parents
Figure 7
Since the top 5 issues comprise over 80% of the PSE's property index, 9M and Q3 revenue, net income, cash, and debt conditions resonate with our earlier discussions.
Anyway, a short note on the REITs included in the PSEi's property index.
In the three quarters of 2023, the Property Index's REITs, which had little leverage, posted net income and cash growth of 8.3% and 11%, respectively. Supporting the 9M performance was Q3 revenue and net income growth of 15.7% and 10.6%, respectively.
REITs accounted for 5% of the index revenues for both periods. It also had an 11.4% (9M) and 11.14% (Q3) pie of the net income of the property index.
As a byproduct of the BSP's EZ money regime, REITs are unlikely to elude the coming market clearing process on malinvestments.
VIII. Mainstream’s Addiction to Inflationism, Real Estate Bubble Equals the "Fictitious Wealth."
Finally, in a recent forum, a top official of one of the nation's leading property firms admitted to the industry's addiction to inflationism.
While inflation poses a threat, it also can serve as a boon to the industry because we know that real estate investment still remains to be a very good hedge against inflation. On one hand, there is the threat posed by inflation as a deterrent to the impulse to invest but on the other hand, it can be the same impulse that will generate more interest in the industry,” Mr. Hernandez said. (Businessworld, November 2023)
Because of duration risk, credit-financed real estate can hardly be a hedge against inflation.
The collateral function of real estate is the anchor of the present bank credit cycle.
Moreover, the performance of RE sales disputes such claims.
Though popular, credit-driven asset bubbles are unsustainable, as the great Austrian Economist Ludwig von Mises warned.
The point of view prevails generally among politicians, business people, the press and public opinion that reducing the interest rates below those developed by market conditions is a worthy goal for economic policy, and that the simplest way to reach this goal is through expanding bank credit. Under the influence of this view, the attempt is undertaken, again and again, to spark an economic upswing through granting additional loans. At first, to be sure, the result of such credit expansion comes up to expectations. Business is revived. An upswing develops. However, the stimulating effect emanating from the credit expansion cannot continue forever. Sooner or later, a business boom created in this way must collapse. (Ludwig von Mises, 1978)
Circling back to the original thesis on the mounting vacancies: Why the cluster of errors?
Central banks (BSP) tampering with interest rates induced false signals that misled entrepreneurs to deploy capital into speculative activities rather than productive investments, resulting in capital consumption.
As the dean of the Austrian School of Economics, Murray N. Rothbard explained:
The cluster of error suddenly revealed by entrepreneurs is due to the interventionary distortion of a key market signal—the interest rate. The concentration of disturbance in the capital goods industries is explained by the spur to unprofitable higher order investments in the boom period. (Rothbard, 2004)
Therefore, because the industry embraced the contortions of Say's Law, "supply creates its own demand," through "build and they will come," their excesses were exposed by the shift to hybrid work and all other factors cited by the global real estate services firm: inflation, high rates, lower economic growth, the exit of POGOs, and cost-cutting measures—most of which are symptoms of malinvestments.
In a recent tweet, economist Michael Pettis described China’s bursting real estate bubble as the unraveling of "fictitious wealth."
Over the past 2-3 decades a huge amount of fictitious wealth was created, with most bank, business, household and government balance sheets, and a great deal of economic activity, being organized around this "wealth" creation.
Rings a bell?
Sadly, the employment of inflationism to generate "wealth," representing a form of redistribution (reverse Robin Hood), would lead to unexpected outcomes for the mainstream.
Yet, this cycle requires the washing out of "fictitious wealth" before a new beginning.
___
References
Charles P. Kindleberger and Robert Z. Aliber; Manias, Panics, and Crashes A History of Financial Crises, 5th edition, 2005, p.104
Prudent Investor, Philippine Real Estate: Mainstream Expert Worried Over Increasing Demand-Supply Gap; Q1 2023 Data of Top 5 Listed RE Firms and the Property Index May 28, 2023
Businessworld, Real estate’s return to pre-pandemic levels seen November 24, 2023
Ludwig von Mises, THE NATURE AND ROLE OF THE MARKET, THE CAUSES OF THE ECONOMIC CRISIS: AN ADDRESS (1931) p 161 The Ludwig von Mises Institute, 1978
Murray N. Rothbard, MAN, ECONOMY, AND STATE A TREATISE ON ECONOMIC PRINCIPLES, The Ludwig von Mises Institute P 1000, 2004
Michael Pettis Tweet on China’s "fictitious wealth," November 24, 2024
