Churchouse Letter
June 2013               by Peter Churchouse

Profiting From The Inevitable Demand and Supply Imbalances in Hard Assets

Inside This Issue:
Supply and demand imbalances can provide key entry point indicators for us. We see opportunities in Asia to pick up some key “Best of Breed” names in the listed real estate space.
Post GFC, low levels of supply in western countries continue to provide attractive price support and further capital gains for key cities like London & New York.
Portwood Portfolio: +2.74% return for the month but elevated volatility continues.

It was 1995 and I was standing in my hotel room in downtown Bangkok, Thailand. I was there on one of my regular regional trips as Asia Strategist at Morgan Stanley visiting local companies. The stock market was running hot, up over 60% in 3 years. The property market was roaring. Looking out the window, I could see construction cranes. Lots of them. I counted 70 across the skyline, and those were just the ones I could see from my room.

The “crane count” on the urban skyline can be a good indicator of near term excess (or shortage) of floor space just around the corner...

A day of research gave me a handle on the numbers. Bangkok was in the process of delivering more than 10 million square feet of new office space over the coming 3 years. In the residential market, developers looked set to be completing around 400,000 units over a similar timeframe.

That was the supply. Recent demand however showed a different story. This booming, emerging city had been absorbing just 1 million square feet of office space every year. The residential bull market had seen recent sales of just 50,000 – 60,000 units annually. The mismatch was plain to see.

...and big declines in real estate prices and financial distress in real estate companies is the likely outcome. Recall those famous photos of the Dubai horizon (and the subsequent “correction”).

Your first lesson in Economics 101 always starts with supply and demand. The ‘laws’ of supply and demand as they are called. For any kind of good or service, the major basis of price boils down to two simple questions; “How much is there available?” and “How much do people want?”.

When there are large imbalances between these forces of supply and demand, there can be opportunities to make money. Real estate is one of the main areas where we often see long lasting differences in supply and demand for floor space, especially in high rise urban areas. It can take many years from breaking ground to cutting the ceremonial red ribbon on a 40 story commercial office building. Real estate is a cyclical beast, but the nature of the real estate development process exacerbates this.

Back to Bangkok and all those cranes. Simple numbers told me the story. Supply looked set to overwhelm demand and prices were likely to fall, even if the current bull market roared on. As it turned out, 18 months later the Asian Financial Crisis engulfed the region. Thailand was ground zero. Peak to trough over 4 years, the local stock market dropped 85%. Property prices nosedived along with the rest of Asia.

After the flood comes the drought as construction grinds to a halt.

How did the property developers fare during this period? The market cap of bellwether Land & Houses PCL (LH: TB) fell over 98% from $3.82 billion, to just $63 million! These days it’s back to $4bn, a 60x return if you were bold enough to re-enter the stock in 1998!

Another company I followed then, Property Perfect PCL (PF: TB) went from a $627 million market cap to just $647,000!!! An extraordinary example of wealth destruction. The company today has a market cap of $325 million, a 500x increase from the depths of the crisis!

Buffet is right: buying when others are fearful can be profitable, but it takes guts.

Beginning of a New Economic Cycle - New Supply is Typically Low as Demand Picks Up.

Let’s think in simplistic terms about the nature of the economic cycle, starting at the bottom. As an economy recovers, investment gathers pace and consumer demand picks up. As the recovery gathers momentum, demand for floor space starts to accelerate. More houses, more shops, bigger offices and new factories. More jobs and high incomes attract households back into the property market and they commit to buy or rent or upgrade. Typically interest rates are low at this point in the cycle and cheaper mortgages (coupled with cheaper property prices) make it easier for first time buyers to come onboard.

As the cycle turns upwards again, new demand faces restricted new supply of available floor space.

Employment picks up and businesses need to find bigger offices or upgrade. So far so good.

However, in the early stages of recovery, supply may lag behind as new building construction has fallen heavily during the downturn. Property development companies may have run headfirst into the slowdown brick wall with high leverage (debt) and ended up in financial stress. Spain and Ireland are good examples of this today.

Current construction patterns in most western nations today illustrate this. New starts in construction in most forms of real estate in many developed markets are well down from levels of the mid 2000’s. The number of housing starts is at a cyclical low in major cities from New York to Sydney. At the same time demand is starting to pick up again on the back of low interest rates, improved availability of finance and some improvements in overall economic prospects.

In Real Estate New Supply Lags Increased Demand - Often by a Long Time.

Back to supply and demand. In real estate there is time lag between new demand appearing and the ability of developers bringing new supply to market. Obtaining land takes time. Planning and building approvals can be laborious. Constructing the floor space itself can’t be done overnight. In high rise environments it can take five years or more from the start of land acquisition to project completion. Often it takes much longer, particularly in cities where planning approvals need lengthy negotiations and bureaucratic reviews.

Even in development friendly Hong Kong and Singapore it takes time. I know from personal experience. Try getting planning and building approval for a high rise housing development in London, New York, San Francisco, Sydney or a host of major developed world cities. It is a painful, frustrating, long winded, and expensive process.

What does this mean? It means that it takes time for demand to be satisfied. Demand can appear quickly. Supply takes time, and by the time supply appears, demand may have peaked, prices are high, and the economy enters a more modest period of growth...

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