The song from which this article takes its title was released in 1984 by English band Dead or Alive. Closer to a one-hit wonder than more legendary English bands like the Beatles or the Rolling Stones, Dead or Alive none the less struck gold with this song rising to the very top of the UK pop chart in March of 1985 and peaking at 11 on the US Billboard Charts in August of that same year. Unlike many pop hits of the 1980s, the song endured, recently being voted #17 best UK 1980s single (out of the 191 songs to hold the spot). For those of you interested in such thing, the #1 song in the poll was the Police’s “Every Breath You Take”, just squeaking by Michael Jackson’s “Billie Jean”.
This has little to do investing or economics other than this song came to mind after the March Fed governor meeting when Jerome Powell’s post-meeting speech officially and unequivocally reversed the Fed’s tightening strategy. Ironically, Dead or Alive’s vocalist Pete Burns, who wrote the song in the title, has implied that the song came together almost more by mistake than any specific inspiration.
As longtime readers of the Altus Insight know, I have often been cynical of the Federal Reserve’s meddling in the economy. Not about any particular governor or their intellect, but the hubris of believing that a few people in a room know better about what needs to happen with monetary policy than the millions of daily transactions with the US economy; and the quite obvious kowtowing to political whisperings despite claims of utter independence.
Conversely, I was encouraged by the first couple years of Jerome Powell as Fed Chairman. Not necessarily the policy decisions (the balance sheet reduction had a far greater impact on market conditions than did the interest rate increases), but his willingness to ignore the President despite the increasing abuse. Additionally, comments and actions indicated the Fed was pulling back from its fourth (self-imposed) mandate, stock market health. By focusing on its three official mandates, the true health of the economy could be more in focus.
In December there were indications this could be changing. On March 20th all questions were removed. The speed of the Fed’s about face from last fall is stunning. Whether this change is due to caving to political pressures or to true economic data changes hardly matters. The reputational damage is done, and the market, world leaders, and domestic business leaders now openly questions the Fed’s independence. The ten-year interest rate, already trending downward, plummeted. All these changes won’t change our lives from one day to the next, but since the Fed’s perceived independence has been such an important part of the US dollar maintaining is reserve status, the longer-term fallout to the economy could be substantial.
So, what does this all mean for investors? I think it is possible the about face in monetary policy will push back the economic slowdown slightly, though after the Fed meeting the 3-month T-bill interest rates rose above the interest rates for the 10-year notes, a commonly used gauge of an official interest rate curve inversion. Yield curve inversions have preceded before all nine of the most recent US recessions, indicating a recession is on the way. The longer the recession is pushed out, the worse of a recession it is likely to be.
The fall in interest rates may keep the foot on the peddle for a little longer in the stock market as well, but I am a little cynical about that. I can’t find the statistic now, but I have seen research that showed a certain number of stock market moves over 4% (up or down) only occurred in bear markets, and the 4% moves have already occurred. That would indicate we are in a bear market currently and we won’t regain the market highs achieved last October. I have very little stock market exposure, so this conversation is personally more a curiosity than personally impactful.
Where I, and Altus, have lot of exposure is real estate. Interest rates have a direct impact on short to medium term real estate price performance. The ten-year treasury, which is the commonly used interest rate gauge for our business, has fallen over 80 basis points since its high last November. That is a 25% decrease. Over a long enough time horizon, cap rates and interest rates move in tandem. This would extrapolate to a 33% increase in market price, assuming no change to net operating income. And assuming a relatively common 65% loan to value structure, thus indicating 35% equity in the property, this extrapolates to an absurd 95% increase in the equity in the property. All without any change to the performance of the property itself. As an aside, this is also why at Altus we are far more focused on value than on price. But that is for an Insight in some future month.
How do these changing interest rate and economic environments change our strategy at Altus? To sound like a broken record, it really doesn’t. An assumed recession within the next few years has to be taken into account in any analysis. But recessions and real estate performance are not necessarily correlated (some property types more than others). We still maintain our long-term cash flow focus (specifically with lots of interchangeable tenants), will still consider entrepreneurial opportunities where we are compensated as much for our creativity and knowledge in specific deal and finance structures as we are in broader investment trends, and, of course, we are still bullish on certain qualified opportunity zones possibilities. We currently have properties fitting all three of these definitions in contract and are highly optimistic on all of them.
The one potential change to our strategy is that with interest rates lower, and by all indications them going to be lower for a while (assuming continued economic erosion towards a recession), we can be more aggressive in our underwriting of repositioning projects using bridge financing. Prior to last year this had been a profitable focus for us, but with interest rates volatile and mostly trending upwards through last year, we became highly conservative in our pro forma underwriting specific to take out financing rates (and therefore cap rates). This completely priced us out of the repositioning market over the past 18 months. There is still a high demand for repositioning opportunities and overall we remain conservative in our underwriting, but we feel like we can tighten up our interest rate and cap rate assumptions. This may in turn free up opportunity we might not otherwise have been able to secure.
Interesting times lead to interesting opportunities. We hope to be able to take advantage of them.
Happy Investing.
About the Author: Forrest Jinks is CEO of Altus Equity Group Inc and a licensed real estate broker. Forrest has decades of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start-up (online marketing and site retail). He can be reached at fjinks@altusequity.com.