Expect the Unexpected in 2023 – Insight For Your Real Estate Investments

Expect the Unexpected in 2023 – Insight For Your Real Estate Investments

Medical Real Estate Commercial Investment

As President Franklin Roosevelt observed over 80 years ago: “Real estate cannot be lost or stolen, nor can it be carried away. Purchased with common sense, paid for in full, and managed with reasonable care, it is about the safest investment in the world.” Recentric shares the same sentiment as our former US president. As we all put our thinking caps on to navigate the economic uncertainties that lay ahead in 2023, we would like to provide you with insights to help you to strategize on the real estate component of your overall portfolio.

Where to Focus Within Commercial Real Estate

For many, stability is the main goal given all the uncertainties both domestically and globally. This makes core and core plus real estate (properties with strong tenants and locations) especially attractive to investors. If you are more concerned about higher return potential, focusing on value-add with a strong operator, and ground up development with a large percentage of pre-leased are the better options.

A Hedge Against Continued Global Inflation

Returns on real estate, farmland and infrastructure typically perform better in an inflationary environment, according to Nuveen’s Global Investment Committee. While offering portfolio diversification and relatively low volatility, returns on these assets have historically exhibited a positive correlation to inflation. On a local level, Recentric has been experiencing double digit returns on its Denver-based health care stabilized assets which has been a strong hedge against inflation.

Fed to maintain aggressive hawkish interest rate approach

Over the course of 2022, the Fed approved seven interest rate hikes, which included four consecutive increases of 0.75%. Despite this very unnerving reaction, inflation continues to remain stubbornly high. The Fed’s only option to slow down inflation and reverse its damaging course is to continue to raise rates throughout 2023, while trying to avoid a recession or worse. Residential and commercial real estate valuations will continue to decline over the course of the year, making for some great buying opportunities.

Aside from location and strategy, real estate investors need to prepare for the unexpected and align themselves with seasoned real estate investment property managers who can handle the occasional hiccup brought by today’s high-inflation, supply-constrained environment. When times are good, investors have a wealth of options. But in today’s market, real estate investment should follow a more focused approach that capitalizes on larger social trends, such as health care which will persist regardless of economic conditions.

How do rising interest rates affect your real estate investments?

How do rising interest rates affect your real estate investments?

interest rates rising

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.

Why Now Is a Perfect Time to Keep Your Powder Dry

Why Now Is a Perfect Time to Keep Your Powder Dry

keep your powder dry

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.   

How’s your capital stacking up these days?

How’s your capital stacking up these days?

how is your capital stacking up?

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. 

Don’t Wait For the Storm To Pass – Dance in the Rain.

Don’t Wait For the Storm To Pass – Dance in the Rain.

Dance in the rain

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.