“The deal of the century comes along every week.”
~ Don “Dad” Jinks
“Buy when there is blood in the streets.”
~ Nathan Rothschild
“Be fearful when others are greedy, and greedy when others are fearful.”
~ Warren Buffett
“Give me a firm place to stand and a lever long enough and I can move the world,” “(and interest is that lever.”)
~ Archimedes (Forrest Jinks)
As often said in the Altus Insight, forecasts are a fool’s errand. And yet, in our business, we have to understand what might happen in the future so we can prepare. At this time last year, no one would have predicted interest rates would be where they are today. And yet, here we are. Some of our projects have been impacted, but overall our portfolio is in excellent shape. While we didn’t expect interest rates to increase like they have, we knew they COULD increase like they have. Our financing decisions over the past several years have been made with the understanding of that possibility in mind, with us now seeing the fruits of those difficult decisions. Now more than ever, the voices of experts are skewed across the board. Going all in on the “correct” forecast would be a huge money maker. But I don’t have that kind of conviction. Thankfully, money, and we think lots of money, can also be made without putting all the proverbial eggs in one basket. But even if we don’t have confidence about what WILL happen, it is still important for us to have an understanding of what MIGHT happen.
While it wasn’t his full-time business, my dad did a fair amount of real estate investing. It wasn’t until I got out of college and started investing on my own that I realized I could learn from his experience. He was incredible at finding the great individual investment opportunities. Largely I didn’t inherit that skill, but through perseverance and putting together a great network and team of talented people, I have been lucky enough to still uncover opportunity. Regardless of what MIGHT happen, there will still be opportunities. If the right combination of things happens, there will be lots of opportunities. I don’t want to say we are hoping for those convergence of events because it will mean pain within the real estate markets; but if there is going to be pain, we want to make sure we are able to benefit from it on the recovery.
What I think I think:
- There will be a recession, just not yet: Interest rates are the price of the use of money. It is the price that is used more than any other price in the world. There is no way that the price of something that ubiquitous can change as much as it has within such a short amount of time and not have an impact (in this case negative) on the economy.
Additionally, we have been experiencing a massively inverted yield curve for months and months. Not all recessions follow inverted yield curves; but I can’t find any situations where an inversion didn’t result in a recession, on average, 18 months after the yield curve inverts. I am not one to bet against the preponderance of evidence.
But… while per capita savings and the savings rate have plummeted (a sign of financial distress), per capita savings (in dollars, not in rate) are still higher than the historical trendline. Government largesse filled private coffers. Those coffers are emptying quickly, with increased stress due to wages not keeping up with inflation; but, with that buffer of cash in the bank I don’t think we will see a recession until later in the year.
- In real estate, an upcoming recession is unlikely to matter – at least not as the key input to real estate performance and valuations: In the real estate world we have far bigger fish to fry than worrying about a recession. Sure, recessions increase the stress of our residents and tenants; but, those stresses are manageable across a portfolio. There are other things that impact real estate, both in terms of performance and valuations. Interest rates are the most obvious; and are the gorilla in the room. Until (or maybe if) people start losing their jobs, I don’t expect to see much distress in single family residential pricing. Price reductions? Yes. Serious distress? No. But that doesn’t mean the industry complex built around residential real estate won’t see distress. Transaction volume has plummeted along with affordability. This will impact real estate agents, home builders, title companies, loan agents, and more. The residential real estate market is heavily weighted to 30-year fixed rate mortgages (at lease in the United States). This means the home affordability of a seller is much, much lower than the same home affordability of a buyer. Or, the affordability of a seller’s home is much, much lower than the affordability of that seller’s replacement property when they become a buyer. Until buyers’ and sellers’ affordability normalize closer to parity, there won’t be a lot of transactions. When sellers have such strong affordability by not selling, this doesn’t create distress.
Financing is a completely different animal in the investment real estate world. Some borrowers take advantage of 10-year fixed rate mortgages (Altus included), and there are a very small group of borrowers that obtain 30-year + fixed rate mortgages (Altus included); but there is a large percentage of borrowers that have debt much shorter than 10 years in length. All bridge loans would fall into this grouping (generally no more than two years in length), as would nearly all debt provided by commercial banks who rarely go to 7 years, and generally don’t like to go beyond 5 years in fixed rate length. According to Trepp, their database of loans shows $53 billion of investment loans, totaling 3,204 properties, coming due in the next 24 months. These loans also have debt service coverage ratios of less than 1.25, generally the bare minimum level at which new financing can be obtained. To make matters worse, this is being calculated off the EXISTING rates, not the new, and much higher market rates. I am not able to confirm the extent of loans included in their database; but calculating the loans in their database to an average loan size of $16.5 million indicates they are not including local/regional commercial portfolio bank loans in their totals, which would increase the volume of loans to be coming due dramatically.
- Bifurcation: There is always some level of distress in the real estate markets. Sometimes property performance is better than anticipated, other times not so much. In times of high liquidity and buyer demand, said distress is largely priced out of the market because the relative cost benefit of buying distressed property versus stabilized properties is minimized through the number of buyers chasing that extra margin. But in normal markets, this distress is generally caused by the performance of the property itself. Sometimes entire real estate segments are impacted, such as what we are currently seeing with most office properties. Whether it is underperformance on a property level or a segment level, it is the performance of the asset that is causing the distress. That is not necessarily the case in the current environment. Most segments (office not withstanding) are performing well at the property level. However, if the underlying cost of financing ownership changes dramatically, as is now occurring and will be occurring more and more in the next 12 – 24 months, the property performance may remain strong and yet the property still enters into debt distress. Owners that have fixed rate debt and don’t have other requirements to sell will largely avoid the distress.
- Opportunity will abound but is likely to be different than most expect: Large swaths of real estate insiders are expecting considerable distress to hit the markets for all the reasons mentioned above. Several of the large real estate investment companies, Blackstone included, have raised huge amounts of money to invest into that distress. Some estimates indicate there is as much as $300 billion of dry powder committed to these funds. Many of these funds are set up such that the companies make good money simply by getting the cash invested, so there is considerable incentive to do so and not return the money to the investor unused. Simple supply and demand indicate that if there is more demand (dry powder) than supply (distressed assets to buy), then the price of the distressed assets will increase, and price out said distress. We can’t really say at what level of cash there is more demand than supply. But relatively speaking, the more cash versus supply, the higher the price of the supply and the lower the relative returns available.
- Sea Change: Howard Marks, one of my investing heroes, wrote a recent investor letter entitled “Sea Change” that is well worth the read. In short, Marks writes that there are sometimes changes to the investing market which are fundamental in nature. One such change was the crushing of inflation in the early 1980s which resulted in almost 40 years of downward trending interest rates. Declining interest rates were a tailwind to asset valuations throughout the 40-year period. Marks feels that trend has been broken and going forward we have to assume higher interest rates, and the potential of considerably more volatility within interest rates. It is unlikely that large investors will eliminate real estate from their investment allocations, but it is quite possible that lower market appreciation results in diminished allocations. That will reduce liquidity within the real estate markets. Those with cash available will win much more so than they have over the past 5 – 8 years.
And it almost certainly true, that if Marks is correct, money will not be able to be made in the same manner it has been made over the previous decades. Many investors practiced a buy and hold strategy based purely on the increase in valuations. Higher interest rates will likely lower valuations to some degree across the entire real estate ecosystem, and rates doing anything but falling will limit valuation appreciation. This means real estate profits will need to be obtained by active management and a focus on cash flow. This is where investors have been outperforming in real estate anyway, so it isn’t a real surprise, but without the tailwind of compressing cap rates (due to falling interest rates), it will be almost a necessity.
What does this all mean:
- By comparison, Altus needs to focus on opportunity and staying up to date on real estate market specific information, versus worrying about a coming recession. This is true for those with stock portfolios as well. In most cases, by the time a recession arrives the stock market has bottomed out and started its recovery. A recession should be less an area of concern and more an indication of the need to not be fearful, and possibly even aggressive, in making investments. We are human, and for most of us it will be impossible to not pay attention to all the financial chatter about the coming recession. But for most of us, it really doesn’t matter.
- While the expected massive inflow of capital into the distressed asset space will likely mute the profits within distressed investing, it doesn’t mean that all profit opportunities will evaporate. We see a couple different ways to compete profitably:
- The large institutions have to place money, and lots of it. That means they need to write big checks on each investment. It is far more efficient that way. We get it, it takes twice as many man-hours to do two $15 million deals than one $30 million deal. But we aren’t afraid of the extra hustle, and we think that wherever the large players’ minimums end up, there will be outsized profitability below it.
- Generally, larger institutions are quite limited in where (geographically) they can purchase property. This will leave many smaller markets ignored. Some of these smaller markets, such as Northwest Arkansas or Charleston, are markets we really like, so the fact that large institutional buyers are looking elsewhere is a benefit to us.
- A large percentage of bridge loans are on properties that were either new construction or being repositioned. Some, or even many, of those properties were not successful in stabilizing after the initial work was completed. The large money allocators often don’t have the staff expertise to deal with real estate problems. They are great at finance, but less experienced at real estate. This works really well for companies like Altus, who are able to step into such situations and apply real estate experience to create value. Not only does less competition at purchase mean higher expected profit margins on the distress purchase; but being successful in solving the real estate problems further increases the profitability. Further, because of the dislocation between short term rates (high) and long term rates (not as high), properties that are purchased out of distress but aren’t stabilized have to use short term rates. That extra burden further diminishes competition and should improve potential profit.
- Shrinking debt availability and the increase in cost of the debt that is available is already starting to kill, or at least delay, new construction. For the most part, the current real estate weakness is not a fundamental issue, it is a financing issue. The financing challenges are impacting projects that would otherwise fundamentally make a lot of sense. This creates reduced supply without a reduction in demand. If (and it is a big if), companies can maneuver the interest rate challenges to get a project profitably done, there is a huge medium-term to long-term benefit of reduced competition for the completed project. While there is always short-term noise, expect rent pressure to remain upward for most real estate classes over the medium term (3 – 5 years).
- Debt is an increasingly attractive play across several different strategies.
- The obvious example is distressed debt. In industry lingo this is normally referred to as NPL, or non-performing loan. Regardless of why it is non-performing, the current interest rate environment makes it much more difficult for non-performers to re-perform. The risk levels of investments made into NPLs can vary dramatically depending on the type of loan (i.e., senior vs. junior), the product type (i.e., residential vs. office), and as with all distressed investment, pricing. This opportunity requires substantial time investment and does not produce much, if any, cashflow, so investors should be looked at as equity growth play.
- Scratch and Dent (S&D): The vast majority of residential loans, and even a considerable amount of investment loans, are packaged into loan pools and sold off in tranches to investors – in theory allocating the risk and returns across the individual tranches. Each individual loan is underwritten to a certain standard which qualifies their inclusion into the pool. The most common standard is Freddie Mac or Fannie Mae guidelines for single family residential properties. Sometimes (often?) the loans are funded and put in place, but then the investor (Fannie for instance) will kick out certain loans from the pool because of technical problems (i.e. missed initials on a page of the loan documents, not enough seasoning time on pre-closing disclosures, etc.). The investors, especially Fannie and Freddie, have increased incentives to kick out loans that were made at rates considerably lower than the current market rates. I won’t go into the details, but in short, mortgage brokers need to clear these loans off their books and often sell them at a pretty nice discount. Additionally, since these loans are performing, nice leverage can be obtained on the purchase of pools of loans, magnifying returns if done correctly. Depending on how an investment into the S&D is structured, some yield can be obtained through this strategy.
- Because cap rates have not yet moved up as much as interest rates (rates are higher than cap rates for most asset types: negative leverage), it is hard to find much in the way of decent yields in new real estate investments. Private debt continues to be an exception. Private debt rates have increased over the past 12 months, but not as fast as bank rates, so private debt is comparably more attractive versus bank debt than it was previously. Because of the difficulties with traditional debt, we are seeing junior position loans becoming used more often and at increasingly high interest rates. This does not mean that the loan has poor collateral, but it must be understood that a junior position loan can be wiped out by the senior loan in the case of senior loan default and lack of action on the part of the junior loan. Senior loans have strong yields, junior loans have great yields. But be careful in chasing the great yields. Make sure you know the risks.
So, what do we do?
Everyone has different financial situations and investment goals. There is no “one size fits all” answer. However, history has shown us over and over that avoiding emotional investment decisions is the sure-fire way to better returns. In looking at the opportunity that we believe is coming down the pike, there are absolutely specific actions we would like to take as an organization. For one, we believe immediate access to investment capital is a must. Two, we need to make sure the way we underwrite purchases and assess opportunities is updated to the reality of a distressed purchase environment. This mostly means shorter time periods from opportunity presentation through due diligence completion, and the need for including conservative assumptions in the underwriting. But most important for us is that we provide opportunities to our investors that are in line with their investment goals. It doesn’t do us any good to find great distressed opportunities with high IRRs but no cash flow if our investors are focused on yield. Conversely, providing investments with solid yield (as compared to the market) doesn’t do us any good if our investors are looking for expected larger returns through distressed investing. It is highly important that each individual investor knows what they are looking for in an investment or investment strategy. And it is highly important that we, as Altus, put in the time to understand our investor’s goals, and provide a product(s) that fits.
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 email@example.com.