Altus Insight January

The Altus Insight
Market news, commentary and relevant topics for today’s alternative asset investor

Date: January 31, 2020
FR: Forrest Jinks
RE:  Twenty-Twenty Vision

 

At first consideration, the title of the first Insight of the year 2020 couldn’t be more cliché. But Twenty-Twenty Vision, and therefore the hindsight 20/20, is not what most people believe it to be. Twenty-twenty vision is defined as the ability to see clearly at 20 feet what the normal human sees at that same distance. In other words, 20/20 vision is not excellent, it is average.

Making projections is something of a fool’s errand. It’s difficult enough to understand what is going on today in the macro-economic and geo-political world, let alone be able to forecast what might happen tomorrow, a month, or even a year from now.

And yet trends, defined as “a general direction in which something is developing or changing”, have outsized impact on our investment portfolios. I’m not referring to short term changes in consumer sentiment, but the long-term momentum of shifts within an economy or society (or even world).

Scribes poopooed the printing press. Blacksmiths laughed at automobiles. Paul Krugman said the internet would have no greater impact on the world than a fax machine. But the printing press, automobiles, and the internet all created seismic shifts on society that rippled throughout the world. If I had 20/10 vision (the ability to see at 20 feet what the average person can only see at 10 feet), maybe I could point out some of these world altering trends. Alas, I feel more like the person in Plato’s allegory of the cave, seeing only shadows from the fire dance on the back wall of the cave. But I think that is probably how most look towards the future, putting me as average. And with that average (at best) vision, this is what I will call my Twenty-Twenty trend vision for the 2020s:

Macro

  1. Analyst John Mauldin often refers to an underlying angst in the American population (and really across many parts of the 1st world). I travel often to different parts of the country and often sense that angst. Residents at some of our less expensive properties certainly exhibit it. And somewhat paradoxically it seems most prevalent among the middle and upper middle classes that live on the coasts. This angst is what led to Donald Trump being elected (and other surprise election results in other country’s) and I believe is behind the ground swell of populism, both right and left, across the world. As the rich increase their earnings and wealth much faster than the middle and bottom classes, and the very policies put in place to try and help the lower classes are demining and hope sucking, and as debt loads continue to grow across the globe, and, and, and..…I don’t see this angst going away until society is considerably more disrupted. Societal and political disruption have an outsized impact on investment returns, and therefore strategy.
  2. I don’t think most people that have the angst can identify what it is. After all, incomes are increasing, we have had the longest economic expansion in history, crime rates are down, and in many senses the environment is healing. And yet according to a recent study done by Capital One and The Decision Lab, 77% of Americans have anxiety about their financial situation. Further, an ongoing (25 year) study done by Cambridge University shows that less than 50% of Americans are happy with democracy, way down from the over 75% in support in 1995 when the survey started. Despite income growth and supposed tepid inflation, people just aren’t getting ahead, nor able to save the way they think they should save.
    1. I think inflation, or rather inflation as it is calculated, is going to become a larger and larger topic in the coming years. The government has incentive to keep measured inflation low as it is the benchmark from which many outflows are increased each year (like Social Security benefits). Since the government also controls the method of measurement, there may be some perverse incentives at play. Hedonic adjustments can be made to minimize almost any sort of inflation, but getting additional cool (albeit unnecessary) features on a car doesn’t get you where you need to go with any more than marginal additional value over the manual with hand crank windows that you might have driven in college. Yet the pickup truck I drove in college was one year old and cost me $13,500. A one-year-old pickup now costs double that (or more). Hedonic adjustments turn that doubling in price to very little inflation (or even deflation), but the true cost to the consumer really did double because it’s not possible to buy the manual with crank windows any longer. If we look only at the expenses in which people don’t have a choice - food, housing, medical, transportation, etc., and ignore the flat screen TVs, laptops, and cell phones; much of society is dealing with serious cost increases. Can inflation continue to remain hidden in the official statistics? Or will a new narrative emerge shining a bright light onto the hidden inflation (including investment asset inflation)? If such narrative is to emerge, interest rates could change dramatically and with a vengeance. This would create massive winners and losers within the investor realm.
    2. But it would be insincere to think that we don’t bring some of this money anxiety upon ourselves through bad money management. Look around when out in public. Twelve-year-olds have $800 iphones. Teenagers are walking around with $160 Airpods. Huge portions of society spend hundreds of dollars a month on Starbucks. This is just a small taste of money habits that quickly add up to drain discretionary income. We, as a society, simply have to start teaching better money habits. There are many reasons the rich are getting richer faster than the rest of society. This is certainly one of them. Bad and worsening money habits will accelerate governments towards outlandish behaviors such as Modern Monetary Theory.
  3. What I didn’t mention in paragraph two is the skyrocketing cost of medical. In the Bay Area it is not at all out of the ordinary for a healthy family of five to spend beyond $25,000 per year on medical expenses before getting a cent in benefit from their medical insurance. There is no question these costs are contributing to the angst and causing families to make decisions for short term survival that hinders long term opportunity. Consider the following example:
    1. Family of 5 living in San Rafael, CA making $150,000 in W2 income. This is roughly 2 times the median household income in San Rafael, so this family is well into the upper middle class.
    2. Assuming a reasonable 401k contribution, federal and state taxes will be somewhere around $35,000. Medical insurance is another $25,000.
    3. Assuming this family owns a median home and has 25% equity, their mortgage payments, property taxes and insurance total another $50,000. This is before any utilities.
    4. Including the 401k contribution of $5000, we are down to around $25,000 in cash flow to cover clothes, vehicles, food, etc.
    5. This obviously is not an upper middleclass lifestyle

There will be changes to healthcare. There is no other choice. And these changes will be large. Being invested on the right side of these changes could be lucrative.

  1. Political uncertainty and vacillations between warring factions creates investment winners and losers. This is especially true among the “insiders” who benefit from the largesse of their connections when those connections are in power. But it is also true for people like me, who without such connections, are still impacted by changes to the tax laws. Even now, relatively early into this polarizing political climate, investing with an eye on net investment returns versus gross investment returns can have an outsized impact on the success of your investment portfolio. The trend I see here is tax laws are going to become more and more complex and have less and less continuity. Those who are willing to invest the time to learn, or the money to hire the learned, will be able to greatly outperform their less tax aware peers by a substantial margin. As a simple example, $1 Million invested for 10 years in a strategy that produces at a 10% return but with annual long-term capital gains on the returns creates a 37% higher return on investment versus that same investment scenario except with the investment creating interest income. That is a huge difference just from one of the most basic tax differences in the code. This isn’t to say we should avoid interest income of course, but tax awareness is vital, and will become more and more so.
  2. The Great Reset – What can’t happen won’t, what must happen will. Debt loads, especially amongst governments and corporations, are considerably higher now than they were in 2008 when a debt implosion created the Great Recession. The Federal Government will run an on the books deficit of over $1 Trillion this year, even in this time of economic growth. Some central banks are already shamelessly buying their government’s debt. The US isn’t far behind. All throughout history there has been a tipping point with debt. Debt is good, debt it good, debt is good…and then debt is crushing. What I believe to be different this time is that the overuse of debt isn’t constrained to a single government overspending on war (France leading up to the revolution), or mania (tulips), but spans the vast majority of western governments and an alarming percentage of large corporations. Debt used properly is a magnificent tool. Overused it becomes a house of cards. Houses of cards will fall, but who knows when.
  3. Robotics and automation are here to stay. While always destined to be part of our future, the cheap and plentiful money available through the actions of central banks combined with the increasing regulatory burden of having employees has sped the arrival of that automation. In the US we have been running at extremely low levels of unemployment for quite some time. While I hope it continues, I see large employment disruption in the coming decade. Maybe those displaced by the robots enter the gig economy. Maybe new industries pop up. Maybe a living wage becomes a reality. Regardless of how it plays out, it will affect everything from consumer brands, to insurance companies, to real estate investors.  

 

Real Estate Investing

  1. More specific to real estate investing, the increasing availability of information is not going away. This will affect everyone in the industry, if their part of the industry hasn’t been affected already. The increase in information reduces the transaction friction in the marketplaces where so often in the past the best opportunities were discovered or created. Ignoring for the time being periods of economic disruption when liquidity squeeze hit the market, I strongly believe that hustle, gumption, and market/industry knowledge will increasingly lose importance versus availability to the cheapest sources of capital; at least as relates to purchasing opportunities. This isn’t to say that there won’t be some hidden gems. The need for creativity wont be eliminated, and strong relationships will continue to matter, but those hidden gems, the opportunities to use that creativity, and the benefit of having relational trust will continue to be less of a factor.
  2. Over more than two decades that I have been in the real investment world one of the most common mantras has always been “you make your money on the buy”. With real estate markets becoming more and more liquid, I see a time in the not to distant future where most real estate sales will occur via some sort of auction, and there truly won’t be money to be made on the buy. Instead, money will be made on the asset management of the investment. Marginal improvements in asset management can have outsized impacts on performance. Most real estate deals are structured in such a way that the sponsor doesn’t see enough financial benefit from improvements for them to do the heavy lifting, so they don’t do it, and instead focus on growing their portfolio. Portfolio growth is a faster way to increase asset management fees than increased performance. In the coming years ongoing performance/execution will be the differentiator.
  3. The way institutional investor deals are structured is going to change. At a high level there is a misalignment of interest between the sponsor and the investor. Sponsors are incentivized (through asset management fees) to do as many and as large of deals as possible, even if the quality of those deals isn’t great, so long as they can get them funded. Institutional investors are also incentivized to do larger deals because they can invest larger sums of money in a single effort, but because the sponsors aren’t incentivized to find great deals, or as mentioned above, push the performance of the property, the investors are not seeing the levels of risk adjusted returns that could otherwise be available to them. As the quality of asset management performance becomes more and more important, compensation structures will eventually change to incentivize higher levels of asset management.  

 

Altus Specific

  1. We are all in on the importance of execution. This includes our back office, our investor communication, and of course, our asset management. All these things have long been important to us, but we have still placed considerable stock in the “you make the money on the buy” mantra. This isn’t to say we are eliminating our focus on finding the hidden gems. Rather, as we see the trend, we are putting more and more resources into maximizing execution, especially at the property level. As I have written about previously, this is not a road that will be without pitfalls (we have dealt with some of the pain this past year). It is much easier to leave “well enough” alone. And in the short run even the numbers might agree. But in the long run, ever improving execution will be a huge benefit to both our investors and to Altus.
  2. Creativity has been a strength of Altus for many years. Not only has it resulted in some outsized investment returns, creative opportunities have also been among the most fun of our investments. Because our involvement in development has been limited over the past decade, most of the creativity has been focused on how we solve problems for the seller. As discussed above, as the real estate markets become more and more liquid there will be fewer opportunities for us to use that creativity on deal specific opportunities. But I believe that creativity will remain important. Rather than focus on creativity at purchase (or sale), that creativity will need to be used to come up with new ways to push asset performance and to create alignment throughout stakeholders. That creativity may turn out to be most beneficial to our investor partners by using it to create broader based investment strategies that take advantage of inefficiencies within the investment world that are not specific to “the deal”.
  3. Along those same lines, I see Altus becoming more and more of an industry leader in tax knowledge and implementation. We have moved this direction in the past couple of years with our efforts around QOZ opportunities, which has been a huge tool for investors willing and able to take advantage of it. We have lots more to learn about existing tax opportunities, and with tax law becoming more and more fluid, we will continue to have lots to learn. With this continuous learning, we should be able to continue to offer investment opportunities that are tax advantaged (like QOZs, 1031s, etc.), but even more powerfully, we are, and will continue be  able to work with investors and their tax accounts to unleash investment strategies specific for their individual situation.   
  4. Altus will continue to grow our capabilities and knowledge around debt. With acknowledgement to the possibility of sounding contradictory to paragraph 5 above, there is a lot of power in debt, especially as the provider of the debt. Just as post tax returns are more important than pretax returns, risk adjusted returns are more important than absolute returns. Debt plays in well here.

Including the sub-paragraphs, I made it to 15 trends to watch over the next ten years.  So much for my 20/20 Vision. But at five pages and growing, I fear I have exhausted the attention span of our readers.

 

Happy Investing.

Forrest Jinks

Altus Equity Group, LP

off: 707/932-5887

fax: 707/544-2972

www.altusequity.com

 

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.