30 Nov 2015

The Day the Debt Canary Coughed

Adam Geha

30 Nov 2015

positioner

Investing in risky assets is a little like underground mining: potentially highly rewarding but also inherently risky.

So much so that whenever you invest cash (a risk free, liquid asset) in real estate (a high risk, illiquid asset), you should imagine yourself entering into an underground mining tunnel. All well and good to forecast great riches, but it will count for nothing unless and until you return safely to the surface (with a realised return).

And given the perils of underground mining, it's highly advisable that you carry a canary along with you.

"If you closely monitor the breathing of the "A-REIT debt canary", you will likely have 12-18 months advance warning to get out of the mine"

Why a canary? Well, as far back as the 1920's canaries have been used by coal miners as an early warning system. The bird's small size, rapid breathing and high metabolism makes it very sensitive to toxic gases.  As long as the canary keeps singing, the miners know they are safe. If the canary grows silent, starts to sway or falls off its perch - the miners beat a hasty return to the surface.

​But it turns out that A-REIT gearing levels actually tell you very little about when you should "rush back to the surface". Take a look at the graph below: in late 2007, the A-REIT gearing level was at its long term average of circa 32%. So if you were tracking this series, you would be forgiven for thinking that nothing unusual was going on.

After a bit of head scratching, we eventually figured out that the reason for the benign gearing level in late 2007 was largely due to rising asset prices (not to restrained debt levels). 

And once we figured that out, it didn't take us long to work out that "dangerous debt" occurred when gearing levels rise or remain stable at a time when asset prices are booming.

Watch what happens to the A-REIT gearing level series once you take into account underlying movement in asset values:

The resulting time series tracks the (debt-fuelled) asset bubble risk with startling accuracy.

PRISMS™ assigns the highest risk score to the "A-REIT debt canary" when the time series rises above 10% (as in 2006-2007) and the lowest risk factor when the time series dips below -10% (as in 2009-2010).

So EG was on high alert when the "A-REIT debt canary" started to cough and splutter as it headed towards the 10% threshold in mid 2014 - but the canary has since returned to normal breathing (a level consistent with its long term average). 

So whenever EG invests in real estate, we carry a few canaries along with us to serve as an early warning signal (18 canaries to be precise).

Each quarter, we shut the shop for 2-hours, gather all our staff in the boardroom and conduct a comprehensive health check on all our canaries. This forms part of our Systematic Risk Assessment under our PRISMS™ risk management software. If the Systematic Risk score exceeds 80 (out of 100), we sound an alert to our cap trans team to rush back to the surface (exit all deals). And one of my favourite canaries is the "A-REIT debt canary".

Now, initially, you might think that tracking the A-REIT average gearing level on a quarterly basis and comparing it with its long-term average would serve as a useful signal. 

"EG was on high alert when the "A-REIT debt canary" started to cough and splutter as it headed towards the 10% threshold in mid 2014..."

This reinforces EG's house view that the current surge in asset prices is largely fuelled by equity, not debt. When debt eventually joins the party, smart investors will rush to the surface. 

And if you closely monitor the breathing of the "A-REIT debt canary", you will likely have 12-18 months advance warning to get out of the mine (market). 

A canary's cough can save your life if you're a miner and - if you carry the right canary - it can save your life savings as an investor.