Property Rentals and Securities Lending. A Non Literal Discussion.
I was in a seminar recently, where the merits of securities lending were being debated. Some quite divergent views were on the table. The following analogy occurred to me:
In the current environment, there is wide focus on financial products being transparent, having risks and fees clearly defined, and being internally simple (no derivatives thank you…). An unintended (or maybe not) consequence is that the practice of securities lending is strongly discouraged. Reasons cited including the effect of short selling (which requires securities to be borrowed), lack of transparency and risk. While some managers categorically do not allow the practice, others refrain because the combination of controversy and the operational requirements make it just “too hard to justify.”
The piece that follows seeks to anecdotally explore securities lending and draw parallels with something completely non controversial – namely owning and tenanting an investment property to receive rental income.
Not lending securities has parallels to owning a property and not renting it out….
Warning: This is not an academic piece. The arguments are not rigorous, and no actions are suggested. These are loose parallels and illustrations by observation. They are analogies intended to generate thinking around the much maligned (in my opinion) practice of securities lending. This is achieved by comparing securities lending to the much less maligned (even favoured) practice of renting out properties. In Australia, many of us are fixated on owning our primary residence. We aspire to owning one or more investment properties. An investment property is widely regarded as a safe long term investment. So comparing investment properties to securities lending may be tenuous (even heretical..), but the comparison does raise a few points worth contemplating. This is especially pertinent, as many asset owners actively stand against lending their securities, and many others are not prepared to oppose this stance. The former regard the practice as contrary to their (and the wider market) aim of maximizing investment returns. (We do not go into the impact of securities lending on the value of securities. There is much academic and empirical work which can be easily accessed via the internet.)
Obviously, the actual differences between property rental and securities lending are significant, however, there are some very strong parallels. If the reader is prepared to be not too literal about the content that follows, then hopefully some insight will prevail. Hopefully, this will filter through to some of the many opponents of securities lending, who are advocates (or definitely not detractors) of using property rentals to generate income. Indeed many institutional funds take this exact stance in their investment allocation and portfolio management.
First, the differences…
Property and securities (especially listed securities) are completely different beasts. The former, direct “bricks and mortar”; the latter, a purely financial, asset. Each exhibits highly different liquidity characteristics, transaction mechanisms and costs. Economically, they are also very different. And, property has a direct utility (it can be inhabited), securities do not.
Property (outside ones own home), is generally held as an investment to provide both income and capital appreciation. Income is generated by renting out the property. Over the long term, properties are expected to appreciate in value. Investment properties are owned with the primary intention of installing tenants who will provide an income stream by paying rent. This income stream is stable and predictable. Running a property also incurs costs (maintenance, rates etc.), which must be covered. Without an income stream, there is a net drag on the overall investment. A landlord would hardly contemplate leaving an inhabitable property vacant.
Securities (stocks), are usually held with a view to price appreciation (not unlike property). They may also produce an income stream in the form of dividends (and in the current environment, dividend yield is highly regarded and actively chased). Unlike a property, securities are just held (or traded). They do not have to be managed or maintained in the same way as property does. Compared to rent, dividend income is not necessarily predictable or stable (with some exceptions). Further, the security owner does not have to install tenants as does a landlord, to receive dividend income. Also, for most retail holders, there are no costs associated with holding a security. Larger investors or institutions may pay custody fees (which are not large, but their overall costs are generally lower than those for retail investors).
Holding periods and risk perception are very different for property and for securities. The latter are relatively easy to trade, with holding periods ranging from less than a day to long term. Property has high transaction costs and generally is a medium to long term investment.
Both securities and property can be financed (ie the owner borrows a proportion of the capital value). The asset is usually used as security for such financing. Interest can be offset by income generated from the asset.
For both asset types, the holder intends to profit from a combination of capital gains and income (with the income generally less certain for securities).
Now the similarities…
Letting a property, is in a sense akin to “lending it to the tenants”. The lender (landlord) retains full economic ownership, and is thus exposed to increases and decreases in its value. The borrower (tenant) has full “access” to the asset in the sense that they can use it. They are beholden to the lender to whom they must ultimately return it. Both property and security owners are exposed to misbehavior by the user (“borrower”). And ultimately, both asset owners will realise a capital gain or loss on disposal of their asset. Both the owner of a property and the lender of a security mitigate their risk when “lending”. The mechanisms for this differ, but the intent is the same – to limit the possible financial impact of an adverse event (a default).
Consider the hypothetical scenario where one owns both an investment property and a stock. Holding for the long term will hopefully result in capital price appreciation. Along the way, income may be generated (dividends from the stock, and rent for the property). This is a default (and desirable) holding pattern. The rental stream will be stable annuity like, while the dividends may or may not occur at all.
Now, if the stock owner has the opportunity to lend out their asset (remember, this is hypothetical). In return for this, they will receive a fee (it may be a direct fee, or as the result of receiving cash at a favorable interest rate. The mechanics of the stock loan will not be discussed in detail here. It suffices to realise that there will be a financial benefit from lending the stock.). Whilst the stock is on loan, income generated will be stable and predictable. It can loosely be regarded as “rent” for use of the stock for the duration of the loan. The stock owner is still exposed to the economic return from the stock (that is, price movements plus any dividends and corporate actions). A collateral mechanism will exist, to protect from loss due to non return of the securities and to limit any exposure due to market price changes. Similarly, a landlord takes security via a rental bond.
Securities lending is not without controversy. There is a vocal segment which frowns outright on the process, citing reasons as widespread as; it being unpatriotic (it encourages short selling), to creating unnecessary risk (which it can if not managed properly). Both forms of “lending” in this context do have risks which must be managed if the outcome is to be positive for the lender.
Let us compare some characteristics of property rental and stock loans.
|Primary aim||To generate (interest like) income||To generate (interest like) income|
|Economic ownership (the “lender”)||Landlord||Stock owner|
|Headline economic exposure of owner (“lender”)||To price appreciation or depreciation||To price appreciation or depreciation|
|Exposure of “borrower”||Rent increases. Termination of tenancy||Rerates. Recall (akin to termination of tenancy)|
|Mechanics||Installing tenants in the property and collecting a regular rent||Lending the securities to generate regular interest like income|
|Agreement||Standard tenancy agreement||Standard stock loan agreement (ASLA, GMSLA etc.)|
|Primary “lending” risks||Failiure to pay rent. Damage. Early termination||Failiure to pay loan fee (default). Failiure to return securities when due|
|Primary risk mitigation||Rental bond||Collateral including a haircut|
|Ongoing risk mitigation||Site inspections, regular maintenance||Margining|
|Normal termination||End of lease||At end of agreed term, or at borrowers option if loan is on an open basis|
|Abnormal termination by “borrower”||Tenants leave or cease paying rent||Default (margin payments not made). Securities not returned.|
|Recourse on abnormal termination||Retention of rental bond. Eviction of tenants if rent in arrears||Retention (perfection) of collateral. Liquidation if necessary|
|Risk on abnormal termination||Damage to property. Loss of income stream and opportunity cost of retenanting||Collateral does not cover value of securities not returned or defaulted payments|
|Mechanism for abnormal termination||Eviction||Buy in|
|Duration risk||Lease is broken prior to term||Term loan is broken|
|Running costs||Rates, insurance, maintenance||No direct running costs|
|Fees||Letting fees, ongoing agents fees||Brokerage, custody fees (possibly)|
These are some of the similarities between lending securities and renting property. They extend to both, the risks and the returns. When the process works, the asset owner benefits with an (enhanced) annuity like income stream. When it breaks down, both the property owner and the security owner may face a loss or an opportunity cost. Both are exposed to what can be termed utilisation risk. This is where the tenant or the borrower abuses the asset. For a property, the result is via defaulted rent, and/or damage. For securities, default on a margin payment or failiure to return the security generates a similar outcome.
There are also a number of technical and market factors which have parallels across property and securities lending. Some of these are outlined below (with apologies for any jargon):
|Property Rental||Securities Loan
|Short Squeeze||Tenants are evicted without notice and “need” to find a new home. May face a price penalty in doing so||Stock is unexpectedly recalled requiring borrower to enter the market regardless of price|
|Fail||Property not ready for tenanting at agreed time||Stock not delivered on agreed settlement date|
|Price changes||Rent review||Rerate|
|Specials||Short term rentals due to special demand situations (like Olympic games, New year’s eve, Summer holidays etc.)||Price spike due to excessive demand for a particular security due to a specific factor (such as a corporate action or major negative sentiment)|
Whilst this is illustrative, this does highlight some of the similarities between renting a property and lending a security. Both are activities which are intended to generate income. Both have inherent risks, which can and must be appropriately mitigated and managed. Ultimately, as a property owner, would one even contemplate leaving a property untenanted (and avoid the risks associated with tenanting). Why is a very similar utility so negatively regarded with respect to lending securities. “Tenant” risk applies to both property and to securities. Yet it is treated very differently in each case.
To those opposed to securities lending – think hard about the practice of renting property. Are you actually just lending your asset to a temporary tenant (borrower). Are you operating from a consistent frame of reference. Tenant, borrower, or landlord, lender – are they as different as they seem at first.
Roger Cohen, June 2013.