Remember the 1970s? Bellbottoms, feathered hair, the peace sign, and the VW Bus. And who could forget out of control inflation! Now that much higher inflation is back, many economists would argue that this time around is different, and we won’t see a 1970’s return to 14% inflation at its height. In 1979, Paul Volker, former chair of the Federal Reserve took a very aggressive stance to put the dagger through the heart of this persistent and destructive invisible force the only way he knew how. Raise interest rates to 20%, and effectively destroy the economy in the short term.
Here are several ways this type of inflation fighting response can affect the commercial real estate markets and your investments:
Increasing rates reset values
Interest rates have increased by at least 3% or 300 bps since early 2022. For example, this equates to an extra annual interest expense of ~$200,000 for a $10 million dollar loan on a $20 million dollar asset. If you were to remove that profit from your return-on-investment calculation, that represents a 14% reduction in total property value (based on a 7% cap rate) showing just how directly and severely higher debt costs affect asset values.
Sellers living in the past
Recentric has made several purchase offers in the last three months, and the trend we are finding is that sellers are still stuck on the higher valuations from six months ago. This gap on the bid/ask price for assets is still very much an obstacle. If buyers leave the market, sellers will be forced to hold on to their assets until the market returns or acknowledge that this commercial real estate market has fundamentally shifted negatively in a short period of time and sell at a lower price.
More competition for commercial real estate
With interest rates on the rise, investors will begin looking at other alternatives. For example, one consequence of rising inflation is that the yields on U.S. Treasury bonds are on the rise. Just recently, the 10-year treasury surged above 4%. Properties that were trading at a low 4-5% capitalization rate become less compelling if the rate on 10-Year Treasury bonds is 4 percent. Risk averse investors will direct their investment funds toward bonds and T-bills rather than real estate providing the same return. Alternatively, the 4 percent “risk free rate” of a 10-Year Treasury bond does not offer any upside or future appreciation, while solid long term real estate deals operated by experienced managers can still offer much higher upside.
As of October 13th, the CPI Index (which does not include energy, food or housing costs) reported that inflation as measured by this index, was 8.2% annually through September. The real inflation rate is likely more in the 12-15% range and having a real impact on people’s ability to make ends meet. The similarities of the 1970’s Nixon administration to pump up the economy by keeping interest rates low in a major inflationary environment to improve re-election chances makes the case that history is repeating as the 2022 midterm elections are upon us. Either way, the US economy has to pay for its rampant spending and draconian government shutdowns on the economy, as the inflation tax seems to be back, in ugly 1970’s fashion.
You undoubtedly have heard the phrase “Keep your powder dry.” The origins of this phrase stem back to the Battle of Edgehill in 1642 in the First English Civil War. Oliver Cromwell told his Roundhead troops in the opening fight, “Put your trust in God, my boys, but mind to keep your powder dry.” This phrase carried on from use in war to more commonly as a financial phrase, to keep your cash at the ready! Here are three signs that the US economy may already be in a recession and why you should keep your powder dry:
Personal savings rates plummet to 2008 levels.
Michael Burry, the author of the Big Short and the predictor of the 2008 recession tweeted out on Friday, “US Personal Savings fell to 2013 levels, the savings rate to 2008 levels – while revolving credit card debt grew at a record-setting pace back to the pre-Covid peak despite all those trillions of cash dropped in their laps. Looming: a consumer recession and more earnings trouble.”
Small business hiring reverses.
The Alignable small business network’s July report showed that 45% of small businesses are halting new hiring. According to the report, “This represents a significant hiring shift, and is largely a reaction to mounting labor costs, skyrocketing inflation, fears of a recession, and rising interest rates.”
Yield curve inversion
A yield curve inversion occurs when the two-year bonds have a higher return than the ten-year bonds. An inversion of the yield curve has preceded every US recession for the past 50 years and has only been wrong once before. This indicator typically calls recessions up to 18 months before they occur. In early March 2022, the yield curve inverted for the first time since 2019. As of July 20,2022, the two-year rates stood at 3.23% much higher than the 3.03% ten-year yield.
More than 80% of Americans now believe the U.S. will fall into a recession in 2022, an April CNBC survey found. And consumer sentiment, as measured by the University of Michigan’s Consumer Sentiment Index, sank roughly 30% year over year last month, closing in on levels not seen since the Great Recession. According to the Federal Research, US households lost 25% of their aggregate wealth from 2007 to 2009.
Even though the White House is changing the definition of a recession, it does appear that we are in one or directly heading for one. Dry powder in the form of cash will provide you with opportunities to be on the winning end of a recession.
The Federal Reserve has decided it’s time to start fighting the worst inflation since the 1970’s, by announcing on June 15, 2022, a 75-basis point increase in the Federal Funds Rate. This is the largest increase since 1994 and one that should not be overlooked. To give you additional historical perspective, the 10-year treasury is the standard to which most lenders in the commercial real estate industry peg their loan rates, and today this number stands at 3.25%, and has increased by 117% in 9 months. Here are a few indicators to provide insight as to where the industry is heading.
Negative leverage in commercial real estate
The single most important aspect of investing in commercial real estate is net positive cash flow. Negative leverage is when the capitalization rate is less than the interest rate assigned to the debt. This becomes an untenable situation for investors. If a buyer currently has a property under contract, and has yet to lock in an interest rate, they may have to trade down on the price, or walk away from the acquisition.
Possible Outcome 1: More properties coming back on the market at lower prices.
Commercial loan term cycles
As interest rates rise, and debt becomes more expensive, overzealous buyers who paid a premium at the top of the market, and leveraged with debt to excessively high levels, are now being forced back into an increasingly hostile debt market with tighter lending criteria and more expensive debt service. According to Trepp, an estimated $450 billion in CRE loans will mature in 2022, a new annual record.
Possible Outcome 2: More properties falling into default by lenders.
Small Business Defaults
Higher interest rates not only affect real estate markets. They affect small businesses that rely on debt to finance their business, from receivables, to equipment and leasehold improvements. According to Markus Lahrkamp, a managing director at advisory firm Alvarez & Marsal, “The first wave of real distress is probably going to hit us kind of mid-year. For the first ones, they might have too much leverage, they were not prepared, the companies were not operationally sound. And then from there, it will probably trigger into more and more.” When businesses don’t pay rent, commercial real estate suffers. Watch the Business Bankruptcy Meter to help determine the health of the overall CRE market.
Possible Outcome 3: Small business bankruptcies may cause more commercial real estate to default on loans.
The inflation tax is inescapable, and extremely hard on the poor and middle class, especially seniors who live off fixed income. We could argue who caused this inflationary environment, but I would rather talk about how to profit from predictable factors that may cause distress in the commercial real estate market.
Disruptions in the marketplace are when opportunities arise, and this may be one of the best times to start thinking about where and who to invest with in commercial real estate.
The US economy seems to be at an inflection point and heading downward. Inflation rates are reaching levels we have not seen since the late 1970’s. The US consumer, which accounts for two-thirds of our domestic economy, is struggling to keep up with the cost of living. The easy money policies of the American central bank are coming home to roost. Many experts including Elon Musk are calling for a recession.“This will probably be tough for some, and this might go on for a year, or may be 12-18 months.” Cryptonewmedia.
Instead of hiding from the storm, now is the time to create a plan for investing before the recession begins:
Dance 1: Keep your powder dry.
Now is the time to start paring back on non-essential purchases (this does not include Fine Wine for those wondering). Call for a family or company meeting and discuss ways to cut back and start allocating money to a “rainy day investment fund.”
Dance 2: Choose your dance partner now.
Sam Zell, the king of commercial real estate, made his fortunes in down economies. In his article, the Grave Dancer, he illustrates the eerie similarities of today and the high inflation environment of the early 1980’s, real estate oversupply and a short term infusion of capital into the markets. Do your research now to align your interests with investment managers who focus on opportunistic areas of real estate. As the markets begin to stress, opportunities will begin to materialize. When there’s blood in the streets, that’s the time to buy. Recentric is in the process of exploring an investment fund to capitalize on distressed market conditions, should they arise. Stay tuned for more information.
Dance 3: Move those inflated investments to gold.
While gold may have lost its luster to the cryptocurrency industry, no other form of currency has as much of a history as a tried-and-true medium of exchange and store of value. For example, during the Great Recession, the value of gold increased dramatically, surging 101.1% from 2008 to 2010, according to a report from the Bureau of Labor Statistics. Be sure to consult with your investment adviser before making any decisions with your stock portfolio or any other investments.
In my April 2022 newsletter article, Control What you Can, and Plan For What You Can’t, I explained that you can create a plan for things you can’t directly control. We have seen this movie before, as recently as 2008, and we know how the movie ends. If we know we are going into a recession, you might as well not hide from the storm, but instead dance in the rain and when the clouds clear, you will be in a better financial position.
Predicting the financial future of the world is impossible but paying attention to certain historical trends which are repeating themselves right now can indicate where the future is heading. And then throw in the likes of digital currencies such as Bitcoin, that have no allegiance to any sovereign nation, and you get the feeling that all currency hell is about to break loose. Paying attention to the following indicators can help you start to make moves to protect your portfolio.
Keep your friends close and trading partners closer
The US trade deficit measures the net balance of imports vs. exports with a particular country. The following chart shows the extreme imbalance the US currently trades with China, which makes us vulnerable to trade wars and supply chain disruptions. On top of this, we are exporting our US dollar for goods that are imported. Should China decide to no longer to accept the US dollar as payment for goods, we could find ourselves in an unwinnable trade war.
As US fiscal and monetary policy of massive dollar printing continues with the Biden administration, the inequities between the rich and the poor have accelerated. This social instability is seen as a weakness by our global adversaries. In fact, according to CurrencyTrading.net, there are seven nations planning a dollar coup against the United States which should raise alarm bells for our citizens: China, Saudi Arabia, South Korea, Venezuela, Sudan, Iran and Russia. Should China alone call in its approximately $1 trillion in US debt, the demand for the dollar could plummet, disrupting markets worse than the 2008 financial crisis.
The Black Swan – Cryptocurrency
According to author and hedge fund manager Ray Dalio, in his book, The Changing World Order, the last three major powers who held global reserve currency status were the Dutch Empire in the 1600’s, the British Empire in the 1800’s and now the United States Empire which has held reserve currency status since the 1930’s. Many are predicting that the Chinese Yuan is the next currency to be held as a global medium of exchange. However, it may not be a sovereign nations’ currency which holds that next top spot. It may be cryptocurrencies because of their decentralized nature, transportability across national borders, and the fact that they are impervious to government corruption.
There are some strong warning signs that the 200-year run as the preferred global medium of exchange for the US dollar may be coming to an end. I would strongly encourage you to watch this video, from Ray Dalio to understand historical trends and how it relates to the rise and fall of global powers. History has a way of repeating and recognizing the patterns in modern day life could be the best way to predict your financial future. However, this historical shift may have a crypto twist!
Have you ever watched a peacock strut around on full display? From a human’s perspective, we believe a peacock is a beautiful, proud and slightly arrogant animal.In reality, they are just trying to court another peacock.
Certain global capital markets have an amazing way of emulating a glorious peacock, but the reality of those markets might just be a feather duster.
Back in 2001, during my internet wine auction house days at Winebid.com, there were many peacocks running around on full display, with dot.com business models that were pumped up with hype and meteoric pro-forma projections such as Pets.com, Drugstore.com and online grocer Webvan. All these businesses are now feather dusters.
To protect your portfolio, and provide you with insight, here are a few feather dusters you should avoid:
Bitcoin as store of value
Bitcoin has often been touted as a store of value, similar to gold and the US Dollar. However, the value of Bitcoin dropped 54% in one month on May, 19th 2021 from its all time high in April 2021. Furthermore, Bitcoin has no underlying intrinsic value, which is a large reason for the extreme volatility. Bitcoin is not used to facilitate daily transactions, nor is it adopted as a reserve currency by any country in the world. At this moment, Bitcoin is purely speculative, and is at risk of being viewed as an outcast by major economic world powers.
Unless you are lucky enough to invest in the top 10% of Initial Public Offerings, you run the risk of negative returns. In a recent Nasdaq study looking at companies three years after their IPO, the study calculated that almost two-thirds of all IPO’s are now underperforming the market with 10% lagging behind overall market returns. Holding onto those investments which seemed exciting at the time, cost investors money. Lately, we have been investing in late stage, pre-IPO companies through several secondary investment funds with strong track records, a.k.a., buying from the inside. Once a company executes an initial public offering, you are buying stock from the outside and much of the value has already been squeezed out. The key to assuring solid returns is to buy the stock from the inside.
Investments that are too good to be true
If it’s too good to be true, it likely is. There is a reason that Bernie Madoff was the most successful Ponzi scam artist ever, stealing over $18 billion from investors. He promised higher than average returns without fail while seducing and abusing his personal network.
However, it takes two to tango. Investors were naïve enough to not perform their own due diligence. “The financial mechanisms behind the con man’s moneymaking scheme are always secret or hard to verify,” Tamar Frankel, a Boston University professor said. “There is always a smell of illegality, persistent but subtle enough that people are willing to overlook it in order to get at the financial returns.”
Investing can be a risky business.
We all make mistakes along the way; however, you can learn from others to prevent the same mistakes. Peacock investments sometimes show up in beautiful and alluring packaging, but without doing your due diligence, you may end up with a feather duster. As always, consult your financial advisor and trusted sources before you invest in any opportunities.
Please reach out any time if you’d like to discuss why we believe investing in commercial medical real estate is not a peacock or a feather duster.