Altus Insight January, 2018

~~The Altus Insight
Market news, commentary and relevant topics for today’s alternative asset investor
Date: January 31, 2018
FR: Forrest Jinks
RE: Strange Days

It pains me to say it, but the economy really has seemed to benefit from Trump’s election. I don’t have any scientific proof as to why, but I believe it is a confluence of several factors.

1. Many people spent the previous eight years quite pessimistic about the economy. Trump’s election turned a few of those outright optimistic. I think more common was a decrease in pessimism. Consumer confidence is a huge short term factor in economic growth, with even marginal increases in confidence going a long way. Especially when that confidence is backed by…

2. A strong stock market. It is no secret stock markets exploded upwards this past year. I don’t need to tell you that nearly all this growth was due to price to earning expansion, not to growth of profits, but where the growth comes from doesn’t change the positive emotion around that growth. Individual investors are now putting money into the stock market compared to cash savings at the highest rate in the past 100 years. The narrative around the stock market gains was the coming tax bill, although the gains far exceeded even the most aggressive expectations of tax cuts, many of which didn’t occur. However, many, many large investors do not invest based on what they think will happen to the market and/or the economy. They invest based on what they think other people think is going to happen. With a large majority of institutional participants in the financial markets believing most other participants were thinking we were in for growth, combined with the confidence of the retail investor jumping in based on the market gains already created, and we have a self-fulfilling prophecy of stock market gains being a bit of a tailwind  into economic growth.

3. Points #1 and #2 miss the one area that I think has contributed to true growth. Despite rhetoric, regulation hasn’t decreased over the past year (with some exceptions) but the growth of regulation has slowed. The previous eight years were difficult on business from a regulatory perspective and the slowing of new regulations feels like a monkey off businesses’ back. Most business owners I know don’t pin their hopes on a strong economy to try and grow their business. They would prefer a predictable business environment where good and bad decisions are rewarded appropriately based on the decision, not a change within the economy or to regulations that takes the success of a decision completely out of the business owner’s hands.
In the third quarter of 2016 many analysts I read thought an economic slowdown was near. Maybe nothing major, but definitely a slowdown. This was even seen in the real time GDP measurement done by the Atlanta Fed. No one is saying that now.  This doesn’t mean there won’t be a slow down or recession, of course, but there aren’t a lot of imminent signs that there will be either. Treasury watchers will point out that the two year yield is rapidly closing the gap on the ten year yield. While it is true we have always seen an inverted yield curve going into recessions, an inverted yield curve does not always lead to recession. (All A’s are also B’s, but not all B’s are A’s.)And there is always the (likely?) chance that the president himself does something to cause the economy to hit the skids; with his insistence on hitting our preferred trading partners with tariffs on products we desperately need (Canadian lumber for instance), and/or his push to reduce the number of foreign born workers in the country/economy (forcing 200,000 Salvadorans residing here due to their 2001 earthquake to leave the country, as an example), or who knows what the morrow might bring.
So where does all this leave us?

• For many years people have expected interest rates to rise. They never did. Now (or at least last year) few thought interest rates would rise, but they are, and seem to be picking up momentum. Many bond classes and durations are now officially in a bear market. What changed? For one, albeit cynically, it seems that the stock and bond markets tend to do exactly the opposite of what anyone expects. More specifically to blame is that while the Federal Reserve is increasing the overnight borrowing rate, they are also starting to unwind the years of quantitative easing. Previously (since 2008), market rates haven’t been willing to follow the changes to the overnight rate, but the QE unwind has direct and far reaching impacts into the economy. In effect, a QE unwind reduces the money supply within an economy. Since interest rates are the cost of money, a reduction of money (supply) will cause interest rates (the price) to go up unless there is a decrease in demand for the money. To date, there has been no decrease in demand. In fact, across all the major categories in which debt is tracked, the US is more indebted now than in 2007/2008. While considerably off the bottom, we are still at historically low interest rates. If, and it is a big IF, this is the reversal in interest rates that has been long expected, we could be looking at much, much higher interest rates a few years from now.

• Following the supply and demand train of thought, the way the Federal Reserve is draining liquidity from the economy is through a reduction in purchases of federal debt instruments. This is a reduction in demand for those bonds. There is certainly no decrease in supply of those same bonds. This will decrease the price the market is willing to pay for the bond. Bond prices and interest rates are perfectly inversely correlated (by definition). Bond prices down, interest rates up.

• The Fed’s purpose and plan has been made known, and interest rates are starting to respond, but like turning an aircraft carrier, unwinding the level of QE that the Fed instituted will take considerable time. That leaves us in a period of time where, despite the Feds move to quantitatively tighten, there is still a ton of liquidity in the investment markets. As it has been over the past several years, that liquidity is chasing purchasing opportunities like mad, hoping/searching for yield.

• Like bond yields and bond prices, cap rates and investment real estate prices are, by definition, perfectly inversely correlated. Increases to interest rates will eventually lead to increases in cap rates. Increases in cap rates means lower market prices. What we don’t know is how much the interest rate – cap rate spread can continue to compress before cap rates change direction and move higher. The impact of rising cap rates should not be understated. While no one knows what the future of interest rates hold, we do know we are still well below historical averages. The current prime rate is 4.5%. The historical average going back to 1950 is 6.65%. For that to be an average that means that there have also been periods of higher rates, in some cases dramatically higher – such as 20.5% in 1981. If we assume interest rates “only” return to the historical average, we should also assume that cap rates will also increase by roughly 2%, although even that could be  understated, since the spread will also tend to rise as interest rates increase (as best as I can tell, this is due to a steepening of the amortization curve). There is no such thing as an “average” cap rate across the country since different geographies and different investment types are all priced differently by the market. However, assigning an “average” cap rate in the 6% - 7% range for C or better quality property is probably reasonable. If a property has a $1,000,000 net operating income in a 6% cap market, the market price of that asset is ~$16.7 M. If that same property produces the same $1,000,000 in an 8 cap market, the market price is ~$12.5 M, or a 25% decrease in market price. This can get scary if we assume interest rates rise past historical averages.
So what do we, as investors, do about this scenario? One thought would be to liquidate everything. Definitely a possibility, but assuming what is being liquidated has been a successful investment, liquidation would result in large tax bills. Additionally, people have thought interest rates would increase for years, and if we would have liquidated six or seven years ago and sat on the side lines, we would have missed out on the entirety of the income and/or price appreciation our investments created. Many investors are trying to figure out what to do. At Altus, we are also deep, deep into this very conundrum. The following are some things to consider:

1. Acknowledging we can’t foretell the future and that we are cash flow focused investors, there continues to be opportunity to identify purchase opportunities and lock in financing within a short time frame. By doing so, the interest rate/purchase cap rate spread is locked for the duration of the loan. Yes, market price might fall, but if the property is providing a cash on cash return, then who cares? Rising interest rates should (SHOULD!) lead to higher rents and over a long enough time horizon the increase in rents should balance out the increase in cap rates. In many markets there continues to be a shortage of available real estate for use. Rising interest rates will decrease new product coming on the market. We are back to supply and demand. No increase in supply paired with an increase in demand will lead to an increase in price (rents). As previously mentioned, there is a lot of money chasing opportunity right now, so being disciplined is key.

2. An attractive alternative to locking in long term interest rates is assuming existing long term interest rates. These opportunities can be hard to find, but they are available, and sometimes competition might be reduced due to less optimal leverage ratios. We currently have an offer in on a property with 32 years remaining on a 3.2% HUD loan. As long term investors, if we are happy with the cash flow at purchase and confident of the location of the property, we feel optimistic of the long term dynamics of the investment.

3. The tax code has a provision allowing for the tax deferred reinvestment of sales proceeds from the sale of investment real estate. We currently have three properties in contract to sell over the next few weeks. We have discussed the possibility of liquidating instead of using the tax deferred exchange with the other parties involved in each investment. One of our partners may choose to liquidate, though we are hopeful they do not. Why you ask? If either the property or investor/owner is located in California (other states will vary), the tax on the gains is a little under 40%. However, it isn’t just the forty percent charged on the net proceeds from sale. The investor is also hit with a recapture of the depreciation taken over the life of ownership. This can easily push the tax as a percentage of proceeds past 50 or 60%. At a 50% tax bill on proceeds, a reinvestment that could have paid 6% cash on cash then needs to instead produce 12% cash on cash to provide an equivalent yield.

4. Other opportunities lie in investments that have more than one exit strategy. I don’t mean slight variations of the same strategy, but completely different strategies all together. For instance, we are currently underwriting a portfolio of 255 single family houses in central Texas. Because of the bulk purchase we would be negotiating the purchase based on the investment return dynamics of the portfolio. However, those single-family homes could also be sold as just that, single family homes. The individual market prices of those homes are far less likely to be as directly impacted by rising interest rates. Having multiple options is good.

5. As more and more money flows into a market, there generally is less and less need for creativity within that market. A seller doesn’t need creative solutions when there are a multitude of buyers. However, if less creativity is needed within the general market, the higher the premium for the creativity when an opportunity requires that requires it. We received verbal acceptance of an offer we made on 10.8 acres of bare land in Georgetown, Texas. Yes, we have strayed farther and farther from development over the past few years as we have focused on cash flow producing properties, but hear me out:

a. We will purchase the property without debt, giving us the ability to ride out an economic hiccups

b. We are purchasing the property around $2.25/ft versus market comparables of $3/ft. How is that possible?

c. The property is currently owned by the railroad, who no longer needs it, but it is also in line for a major state highway expansion that would use ~50% of the property. This restricts a developer’s ability to immediately start building on the property (there is huge demand for office and industrial in this area). Developers don’t want to wait, that isn’t their business. However, eminent domain (or the threat thereof), generally comes with a pretty hefty price tag for the government entity needing the land; usually considerably above market rate. Assuming we only achieve market rates it is a 33% increase in value. We are shooting for $4/ft, over a 75% increase. We can do this because we can be patient (and would only take patient investors into this deal), have plenty of experience in dealing with government agencies and specifically eminent domain, and have a strong network within that geography with whom we can either partner or sell the property to for the remainder portion to be developed. When opportunities are few and the future hard to decipher, we have to think outside the box.

6. While there are likely other strategies I am overlooking, the last strategy I will mention is redundant to previous Altus Insights: Private Debt. There are drawbacks to private debt, mainly the lack of beneficial tax treatment and omission of appreciation upside, but when there are severe economic unknowns, especially as relates to interest rates, private debt can provide consistent cash flow and should provide a strong buffer against falling market prices. Additionally, due to the normally short-term nature of such debt the investment can be adjusted as market conditions warrant. We are currently researching/brainstorming a debt fund structure that would allow investors to choose between either greater loss protection, or much higher returns by taking on additional risk.
It is an interesting time here at Altus. There are always investment opportunities to consider, and when market corrections come there will be even greater opportunities. But now more than ever, we have to stay creative, patient, and disciplined.


Happy Investing.

Forrest Jinks
Altus Equity Group, LP
off: 707/932-5887
fax: 707/544-2972