Hedging Economic Cycles

Hedging attempts to reduce risk from fluctuations and inevitable downturns in the market. Unlike many securities and futures, physical property assets cannot be perfectly hedged as property is a complex cocktail of risk factors. My planning strategy for the 15-bed HMO refurbishment is an example of hedging. Rather than creating two large seven- and eight-bed HMOs, I configured the property
into four smaller HMOs. I chose this strategy because I took into account the potential downside of future tenant demand trends for HMOs and the possibility that I may eventually need to withdraw from the HMO market. I also considered the potential worst-case scenario in terms of future legislation
changes, and the possibility of local councils charging commercial rates on large HMO buildings.

A fixed-rate mortgage is the main defence hedge against inflation-driven mortgage rate rises, such as those that happened in the 1990s recession. These effectively work as an insurance policy against interest rises by establishing a set level of interest for your repayments. However, they tend to be more expensive,and if interest rates actually go down, you won’t be able to take advantage of the savings. Hedging is about being aware of the cycle. Billionaire investor Howard Marks says: “Ignore economic cycles at your peril.” As the CEO of Oaktree Capital and one of the top ten most successful investors in history, his advice on cycles should definitely be heeded. As I see it, property is an asset with cycles, just like stocks and shares, going up and down. Forecasting the timing of these cycles is totally pointless; all you need to know is that the downturn will come sooner or later.

However, in many (but not all) UK cities, we are close to oversupply, particularly for one and two-bed apartments. In London and some southern cities, we are at the top of the cycle in terms of yields and HPI (house prices to earnings), so buying a less speculative product than new build flats helps to reduce risk. I have lived through two recessions. I progress without fear, but I am also conscious that
understanding cycles is important if I want to tip the odds in my favour in the event of a slow-down.

When it comes to managing and hedging property risk, it is important to consider the practical implications of what actually happens during a recession. The bargains you expect to take advantage of
don’t always materialise. The recession makes it much harder to raise finance and the market is no longer fluid, with fewer transactions. Any recession strongly favours cash-rich investors over your average investor. When sentiment turns, trying to guess the bottom of the market is impossible, so it takes a brave person to buy while prices are falling.