O ver the last couple of years - starting before the pandemic - real estate capital values have been slowly falling. Then, the fundamentals deteriorated during the pandemic and now, as we slowly start to emerge from the restrictions in the UK (Continental Europe will be lagging), uncertainties and risks will start to rise. We should expect the real estate asset/fund managers typically to move through two phases in their responses. The first is one of denial. They continue with their fund-raising activities, convinced that nothing has really changed. Indeed, they argue, the fundamentals are better than ever. Interest rates in Europe (including the UK) are at historically-low levels, as the bond yields are not far off their historic lows – and the latter represent the risk-free rate base from which property assets are valued. The yield premium between bond yields and property yields, often mistakenly referred to as the risk premium, is at an exceptionally high level, making property look ‘attractive’ in an historic context. What is usually ignored in this analysis of the situation is that investors (including the fund managers’ clients) have a perception of capital value growth expectations and a view of the risks surrounding those. These are set against their target rate of total returns, typically an ungeared/unleveraged 5% or 6% p.a. in theory, but rather more in practice, with debt raising it to around 7.5% p.a. or more. If prices were stable, most of the returns can be achieve through pure income and, but with the falling yields of most of the last five years, together with gearing, the annual total return has often reached double digits. This expectation can easily reverse, and investors can foresee negative returns. Globally, this has fed through to through to real estate buyers becoming nervous. According to Real Capital Analytics (September 2020), the percentage of agreed transactions that subsequently collapsed reached a peak in 2020 at about 5% in the Americas and Europe, equivalent to European peak in 2012 and above its peak in 2008/9 (although the Americas peaked at 22% then). What is surprising is not, however, the peaking at 5%, but the factr that it is not huigher. This suggests that there are a number of purchasers in the market who felt committed to tghe deal or who believed that any additional risk was of a purely temporary nature. Typically, in this denial phase, little notice is taken of the types/identities of buyers and sellers who are, or are not, in the market. If they did, the difference between the buyers and the sellers would be a useful indicator of what is happening. As one senior fund manager once said to me: “I never buy from anybody who is sharper than I am”. Some other asset managers convince themselves that, with less competition, this is a buying opportunity. The second phase is one of convincing their clients that the investment strategies should not be deflected by short-term consideration. Real estate, it is argued, is a long-term investment and transaction costs – both buying and selling – make market retreats an expensive operation. The cycle is just that: a cycle. There is much merit in such a position, but it ignores one essential factor: individual properties rarely come out of the cycle in the same form in which they went in. Paraphrasing what a senior manager of a German open-end fund said to me when he came to sell properties at the time of the fund’s liquidation: “I don’t understand it. I bought core properties when the fund was in the investment phase. Now, when I come to sell them, they are value-add properties”. He might have added that some of those that were really value-add had become opportunistic. Many of the properties were sold at 30%+ below their current valuations well into the recovery of European markets, suggesting that even the valuers had not properly understood what had happened. The problem is that, other than prime, the depreciation in properties during a down-turn, when tenant demand subdues, accelerates dramatically. When tenants have little choice, they take what is available and even compete for it. When the market swings the other way, the tenants in poor premises either find better space or fail. The latter are in poor space because their profit margins are thin and are prone to failure The smart, or sharp, investors will try to anticipate the down-turn and off-load their marginal properties. These are the properties that appeared to be ‘cheap’ when purchased in the growth phase and which may have, in that phase, even benefited from a significant ‘re-rating’, producing good but not exceptional returns. My main list of properties of properties in this category runs something like this: Long leased properties let to oc cupiers who would rather not be there. These are sometimes created through sale-and-leaseback, a situation in which the asymmetry of intelligence favours the tenant Buildings and locations that are exposed to the advances of technology, which does not slow during down-turns. This applies particularly to retail property and most of it falls into this category Office and other investments in the fringe of core. If the pedestrian footfall in these areas is poor, with little obvious commercial activity, then this is a marginal location. For these, ignore the building quality Relatively high office buildings with small floorplates. These are inefficient for space users and tenants quickly realise that. A modern building should have floorplates well in excess of 5,000 sq ft (500 sq m) Dilapidated buildings occupied by tenants who can barely afford the rent. They may have been bought with refurbishment/redevelopment opportunities in mind, but a downturn is not a good time to hold an empty building Almost everything that might be described as ‘secondary’ property, even if it is high yielding I do not think that the current downturn will be anywhere near as detrimental to values as, say, that of 2008/9, but it has only just started. What we are seeing currently is an increase in unemployment numbers, despite the government’s furlough scheme (which covers the majority of a worker’s salary, subject to limits) is an increase in company profit warnings accompanied by falls in earnings. That is a prelude to an economic down-turn, which is the real trigger. The down-turn will also be mitigated by the lack of alternative investments and the poor return on cash - meaning that investors will not want to stay out of the market for too long. It is axiomatic that prime property will do well because it provides security of income. But not all prime property is equal. Investors need to retain property where there is value in the building but, equally importantly, in the land. Location, in downturns, is key. Developments may appear risky, but in the right location, they might become the best performers in the next growth phase.