Since the start of last summer the Spanish real estate market is coming back to life after several years in a catatonic state.
The first investments made by foreigners were related to the hunt for yield: mostly bond-like investments with real estate underlying and inflation protection features. Some funds have been holding securities related to the sale and lease back of Spanish offices since 2010.
Then it was the time for commercial real estate, which made sense given that the yields that one could find in Madrid and Barcelona were 50% higher than those of Paris or London, and those higher yields also included huge room for rent growth.
After that, Spanish banks began selling their divisions of real estate management to private equity firms.
Most recently, it has been direct investments in huge packages of dwellings, one of which was purchased from BBVA by Seth Klarman’s Baupost Group, an investment guru who usually buys hated assets (like bonds of Lehman after it had filed for Chapter 11, or shares from Bernard Madoff’s fund after it had blown up) at rock bottom prices.
Taking into account Mr. Klarman’s track record, it seems like a bad idea to be at the other end of one of his trades, even if the trade involves a tiny fraction of the assets he manages.
So I ask: Why is Spanish residential real estate a compelling investment six years after the beginning of the recession? There are two things to keep in mind as you read through this: Major holders of real estate (the banks) have been finally forced to take their losses, and the Spanish economy might be at a turning point.
The Spanish authorities had taken a number of important measures to address the problems in the banking sector before they had to resort to an EFSF loan of €100 billion to cover capital requirements of nationalized banks, as the team that drafted the Memorandum of Understanding on Financial Sector Policy Conditionality (MOU) mentioned in the document.
The measures included the clean-up of banks’ balance sheets to increase minimum capital requirements, restructuring of the savings bank sector, and significantly increasing the provisioning requirements for loans related to real estate development and foreclosed assets (through Royal Decrees de Guindos I and II, see the table below).
However, those measures proved to be insufficient when the capital shortfall of Bankia was disclosed, and afterward, the one of Caixa de Catalunya in May 2012.
One of the major milestones of the roadmap for the strengthening of the Spanish financial sector established in the MOU was the transfer of problematic assets from the state owned banks to an asset management company (Bad Bank) at a price finally established on the basis of the foreseeable loss under the base macroeconomic scenario from the stress tests performed by Oliver Wyman, plus a further discount due to the huge amount of assets transferred from the nationalized entities to the Bad Bank.
With this level of provisioning over the loans (that in most cases weren’t granted for 100% of the asset price), plus the requirement of a minimum rate of liquidation of troubled assets imposed in the two Royal Decrees and the MOU, as well as the banks’ need to reach a 9% core capital ratio on risk weighted assets; the end result is a price adjustment with a lot of assets selling way below their reposition value.
Is this the bottom for Spanish residential real estate? Well, with an unemployment rate of 27%, and the credit to private sector dramatically shrinking due to bank deleveraging and crowding out effects, the bid and offer dynamics for sellers of residential real estate couldn’t get much worse.
But What About the Upside Potential?
Up to now we’ve seen that the investors currently buying are getting a good entry price, but what about the exit? There are certain investors who seem to be buying on the assumption that the residential property market is recovering in the United States, and as such, that something similar could happen in Spain.
But it doesn’t seem like that’s the investment thesis for the most sophisticated ones.
Maybe we can find the reasons behind this investment revival in two reports from the Spanish asset management boutique, Arcano, called The Case for Spain I and II, authored by Ignacio de la Torre, which in October 2012 made a contrarian call warning the market about the historic opportunity to invest in Spanish assets.
The first reason is that Spain has achieved the heroic task of closing a current account gap of 11% in five years without devaluation, making its economy less dependent on foreign inflows.
The second reason is that, thanks to some structural reforms (politically unpopular in the short run, but growth enhancing in the medium run), the Spanish labor force is more competitive, making Spain, along with its infrastructure, security and weather, an ideal place for industrial production.
Mr. de la Torre states that once that the major imbalances of the Spanish economy have been reversed a virtuous cycle for Spain has started, and he forecasts the end of the adjustment in employment in 2013, the end of credit contraction in 2014, and the return to growth in consumer spending for the second half of 2014.
How will this affect the housing market? If we take into account pent-up demand, the low level of new housing starts (less than 20% of the long term average), and the fact that purchases from foreigners are growing at solid double figure rates, we begin to get a rosy picture.
If we include that even at the current rate of sales the stock of unsold homes will be exhausted in less than 3 years in the most popular areas (like the major cities and some areas of the Mediterranean coast), it seems that if one invests in Spanish real estate carefully the only possible way is up.
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