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What to do, what to do…

October 2022 Insight

The news cycles have been chock-full for the past several months. It seems like every day we are hit with new statistics, revelations, or insights. Many, such as the war in Ukraine, a hurricane in Florida, or the election cycle, provide most of us little opportunity for impact (excepting our huge opportunity/responsibility as citizens to vote). The financial and economic news has likewise been hitting us like water from a firehose. Inflation is up, but will come down (someday), unemployment remains incredibly low, government bills have introduced new pain and opportunity for investors, interest rates have skyrocketed, housing activity (and maybe soon prices) has plummeted, and so much more. The Insight has been dissecting said news items for the past couple months. But such dissection, like the accumulation of any information, is only of value if applied. There are investors (as an example) with a disciplined approach to investing that continue to add money to their investment in an S&P index fund through good times and bad. Economic changes and market gyrations have no impact on their investing actions or strategy. There is no reason for such an investor to pay attention to economic and market news. And while the strategies may vary, there are many investors that have similarly disciplined and generic investment strategies. There is a part of me that envies them, and their assumed ability to ignore turbulence around them as they focus on some date well in the future, satisfied for their investment to perform to market.

I am not one of those people. Instead, I have an active portfolio across different asset and investment classes, few of which are traded securities. And I am not satisfied to accept average returns.

Thus, being buffeted with the plethora of economic/financial news and data, my mind often returns back to, “what does this mean for me?”.

Across the past forty years of economic turbulence, there was generally an easy answer for times of uncertainty. Do nothing. Though even across that time period of low inflation, doing nothing still bore a financial cost. The return on cash in real terms is the inverse of the inflation rate. I like to view cash as optionality – that is to say, cash is an option to buy something in the future instead of buying it today; but that optionality comes with a cost, just like purchasing a stock option might. In times of low inflation, the cost of that optionality is likewise low. Sitting on One Million Dollars of investable cash for 12 months during a time period of 2% inflation costs me $20,000 in purchasing power, meaning I spent $20,000 for the flexibility of being able to spend that $1 Mil on an investment in the future versus what is available for me to spend it on today. Additionally, there is the opportunity cost. When markets are moving upwards, my future purchase options are less likely to be as intriguing as they are today; but in times of turbulence, distress in the markets increases my likelihood of identifying a great investment opportunity in the future. And when we have strong investment opportunities in front of us, whether now or at some point in the future, the question becomes null and void until we again have investable cash needing to be placed.

Today, 2022, is not like the past 40 years. Yes, cash is still optionality, but the cost of the option is much, much more expensive as inflation higher than 8% eats away the value of cash. With inflation at 8%, cash held for one year requires a 9% REAL return to get back to breakeven in real terms. Maybe not the end of the world, but what if it is held for two years? Or three? Or over 6% for ten years like it was through the 1970s. It seems unlikely that this would occur, but it has before, so it is certainly possible that it could again. Cash held during 8% inflation for ten years requires real returns of 112% to get back to breakeven. Going back to 1960, the stock market (i.e. the S&P index funds referenced above) has averaged a little over 6% in real returns (nominal returns minus inflation). Stay with me here, as this is astounding. At a return level equivalent to the average returns over the past ~60 years, it would take ~thirteen years to accumulate a 100% return. Or in other words, cash held for ten years during 8% inflation would require 13 years of historically average real returns to get back to zero, the same place as where you started 23 years previously. I, for one, am not willing to accept that outcome. Investing is supposed to help me get ahead – not just to offset inflation – but to build my purchasing power, and, using the power of compounding returns, build that purchasing power faster and faster as time goes along. This requires positive real returns.

Which all brings me back to my question, what should I be doing with investment capital?

Please understand that the remainder of this Insight is simply brainstorming, and nothing should be considered investment advice. It should further be acknowledged that accredited investors[1] have a huge advantage over the general market when it comes to investment opportunities. Much of what takes up my investing brainpower centers around non-market traded investments, meaning they are unavailable to the majority of investors (ridiculous I know – thank the SEC for putting rules in place to give an advantage to those that already have it). Additionally, because of my profession, and because investing is not only my profession but also a passion of sorts, I come across many opportunities that aren’t available to others, even many other accredited investors. Some of these opportunities we try to bring to our investor network, but there are others that we either don’t have enough control over or enough expertise in to expose to our investor network. Lastly, none of my musings contemplate selling existing investments to move into new investments. My mental gymnastics are focused on investable cash. Unless one is pulling money out of an investment portfolio, sales decisions should be made based on the comparative advantage of the replacement investment, regardless of where an investment stands in a price cycle.

  1. Intrinsic Value: A core part of Altus’s investment philosophy is to purchase assets at prices below their replacement cost, or in other words, to focus on intrinsic value. And yet, we are currently working on several new construction opportunities, which has been a focus of ours the past couple years as we determined new construction had by far the best risk-adjusted returns (broadly speaking) available across the real estate segments. Focusing on risk-adjusted returns is another key part of the Altus philosophy. In this case, those two conclusions seem to be in conflict. But there is this pesky little thing we are all dealing with – inflation. The increase in interest rates have killed many new projects, even in multifamily and industrial where the overall demand trendline is up and to the right. If demand continues to grow, but the growth in supply is curtailed, the output is an increase in intrinsic value for projects that are able to be completed. More specific to buying below replacement cost, if we are able to lock in prices on a project today (we are), and the project then extends into the future, in broad strokes and with inflation remaining, we end up with a finished product below the then cost to replace that product. For instance, if we have $20 Mil in hard cost on an 18-month project and the inflation rate is 8% (acknowledging building costs may vary within that inflation rate), at the end of the 18 months our cost is 12.2% below the new replacement cost.

The counter argument is that inflation is going to plummet as we go into a recession. This is a possibility. And if that happens then interest rates will fall, eventually pulling cap rates with them. If we chose our projects well, the product will be in demand even if economic activity softens. With lower cap rates we are back in the money for locking in low interest rates to take advantage of the interest rate/yield on cost spread.

This is admittedly not a consensus opinion, and it can be lonely to take a stand uncommon in the industry. But Warren Buffett made his money not following consensus, and I think we will too. I don’t have so much confidence in this stance that I am willing to bet the farm on it, but I have considerable investments in our current new construction projects and expect to be making additional new investments as our pre-con projects get to the stage of requiring new investment.

  1. Bond Replacement: For decades an investing mantra of investment advisors has been to structure investment portfolios as 60/40 – 60% equities and 40% bonds – with the thinking that boring bonds would limit downside risk during times of volatility and equities would still provide decent portfolio returns (though lower than the S&P historical returns mentioned above). So long as interest rates were falling this was a successful strategy, but when interest rates became so low that the bond payments received weren’t worth mentioning, all (relatively speaking) the bond returns were tied to interest rate compression. Retail investors could no longer hold bonds for the coupons. Then the unimaginable happened. Inflation roared back and interest rates rose. This has created carnage in bond pricing. The ten-year Treasury purchased last year can either be sold at a massive loss, or held to maturity – at a 1.5% coupon rate, meaning a 6.5% real loss annually. The safe, conservative 60/40 portfolio has worse returns than the S&P this year to date. So much for a safe investment structure.

However, there is a way to use the 60/40 structure with better results. Though most financial advisors won’t like it. Instead of focusing only on traded securities (stocks and bonds), open up the world of investments to alternatives. Maybe that includes real estate, maybe it includes private stock investment, but it really should include private loans. Private money, also sometimes called “hard money”, is often viewed as risky by pundits, but this is largely because they don’t understand the functionality. As most will know, through our sister company Altus Capital Group Inc, we arrange private real estate debt, and sometimes consult private companies in obtaining private debt. The most recent loan we completed, which closed on Thursday, was a first position loan at 60% of purchase price at 10% interest for one year. All insurance and property taxes were paid at the time of the loan being made. With 8% inflation, a 10% return equates to 2% real return, and a 2.5 x return versus a 10-year Treasury. Argue if you will that a government-backed bond is more secure. I will say, maybe… Owning the real estate means I am secured by real property. Even if the borrower doesn’t pay, and for some reason real estate prices drop precipitously, I then own a piece of real estate – far below replacement value. Far more likely is I receive monthly payments until being paid off in full, and no longer than 12 months in advance (some notes are longer).

Just as there are various iterations with a bond strategy (corporate, munis, T-bills, etc.), there are different ways to play private debt opportunities. I don’t yet have 40% of my investment portfolio in debt, but am moving in that direction. Part of my portfolio is in safe, low leverage 1st position loans. Another, smaller part, owns second position loans leveraged where I would still love to own the real estate (if I had to foreclose on the property), but with the interest rates being considerably higher than the 1st position loans. Lastly, I have loans out to companies that need transaction financing for equipment purchases, for receivable factoring, etc. In most cases these are more complicated than real estate loans, but if done correctly can have excellent collateral and great coupon rates. Even as late as this past Friday, I continue to add to my loan portfolio. It is worth noting that being accredited is not required for investments in real estate notes.

  1. Distress: I speak to dozens of banks and commercial loan brokers each quarter. Over the last few months, I have consistently asked if they have seen any distress on the part of borrowers or sellers. So far, the answer has always been, “Not yet”. My follow up question to the lenders is, “When?”. The shortest time frame I have received in response is six months. I really don’t know if there is going to be distress or not. It sure seems like a strong possibility, but I thought the same thing during COVID, and it never came to pass. I love distress (not in my own portfolio, obviously), and should it occur, I want to be part of solving it. But if it is that far in the future, and its occurrence is only a guess/assumption, am I willing to sit on cash and pay the damage inflicted by inflation until it comes to pass, if it does at all? I have decided that the answer is no.

Even not being willing to eat the inflation damage, I still want to have optionality, so what to do? One possibility is the aforementioned private debt option. It is short-term enough that I should be able to place money and get it back within the period of distress. But it isn’t liquid, and if there is a default it becomes even less liquid. The calculus comes down to personal preference on returns in the bank versus the cost of the option to participate in the distress should it manifest.

There are other options that are more liquid than private debt, but less costly than holding cash, though still costly in real terms. One such instrument is the Altus Debt Liquidity Fund, with ~4.5% returns and thirty-day liquidity on an extremely low leverage security portfolio. There are debt funds that have higher interest rates, and relatively strong liquidity, but they have considerably higher leverage, and therefore risk of loss. Another option is to purchase rolling short-dated bonds. Corporate bonds and munis offer higher returns, and income from munis is generally tax advantaged, and should have limited price risk due to the short-dated nature of the coupon. It is unlikely any of these options have enough speed to liquidity to take advantage of a particular distress opportunity – after all, distress generally requires considerable speed, but this level of liquidity does allow for participating in a period of distress more broadly.

For faster liquidity, many stocks are now priced at levels that result in strong (4 – 6%) dividends. In theory, stocks with strong dividends should have less price volatility, but that is certainly not a given. Additionally, dividends are paid to the stock owner as of a particular date. If liquidity is needed just prior to the dividend date, there could be three months of dividend-free ownership while still being exposed to loss (or gain) of capital.

  1. Strong USD: The US Dollar is strong right now. Really strong. While slightly off its’ peaks, the dollar is the strongest it has been since the mid-1980s, about the time Volker started dialing back his inflation killing interest rates, with the 1985 3-month Treasury peak being 10.63%. We can see the effects of the strong dollar throughout the financial markets. For one, longer dated treasuries would be considerably higher if not for the strong dollar. Oil prices are high, but much lower than they were earlier in the year when the dollar really started appreciating in earnest. Less obvious to those not in the securities market on a daily basis, stocks listed on markets outside of the US have been considerably more impacted than US stocks. A strong dollar really hurts companies that have dollar denominated debt but earn revenue as non-US (and weaker) currencies.

Many experts believe the dollar’s run upward will continue with Barron’s, Financial Times, the Economists, and others all running feature stories about how the dollar’s upward momentum can’t be stopped. If you believe them, ignore the following ideas.

I, however, am not so sure about the dollar’s ongoing strength. It is rare for a country to have high inflation and a strong currency. The US has managed to do so first because of the rapid increases in interest rates, front running the other central banks of the world. And secondly because inflation rates are now higher in the rest of the 1st world than they are here. There is some evidence that US inflation, or at least its upward trajectory, is starting to moderate. This should provide support for the Fed to slow down its interest rate increases, and maybe even turn to decreases should we have an economic wobble. Meanwhile, other central banks have started to increase their own interest rates in earnest. I have no idea when the Dollar will weaken back to its recent averages, but I don’t believe it has to move far to still have an impact on investments.

There are multiple ways to play a weakening dollar:

    1. Many investors are opposed to hydrocarbon investments. But if you are not, then there are many ways to play oil and natural gas across the securities markets. For those able and okay to take the private investment route, there can also be tax benefits associated with those investments.
    2. An easy button (in terms of placing the investment) is to purchase index funds for companies in various countries and/or regions. These can be purchased on a US exchange, or if there is a willingness to do a little bit extra work, then the same/similar indexes can be purchased on OUS exchanges, in which case the move in dollar strength will be amplified, both up and down.
    3. For those that want to put in a little bit extra work, there are some strong OUS companies that have solid dividends and PE ratios below 10. As a high-level example, the UK FTSE (the top 100 companies listed on the London Stock Exchange) has a PE ratio a little over 14. Conversely, the NYSE PE ratio is over 26. By identifying strong dividend payers in such a market, an investor can have a decent yield while also setting up an investment to take advantage of a rebalancing of the exchange rates.

I am sure there are many more ways to play the current environment than I have dreamed up here. I would love to hear from readers on other possibilities.

Happy Investing!

[1] As defined by the SEC, an accredited investor has a net worth over $1 Million not including their primary residence or has had income at minimum of $200,000 (or $300,000 if married and filing jointly) for the past two tax years. There are some loopholes to qualify for accreditation even if you don’t meet one of the criteria listed above. Please drop me an email to discuss as it may relate to your specific situation.

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.

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