Who is more powerful: the FED Chairman or the President of the USA?
In the age of political fighting, split congress and limited compromise among our elected leaders, the Central Bank Chairman controls the money supply and the cost of money, a.k.a. interest rates. FED’s Open Market Committee (FOMC) makes all important monetary policy decisions. FOMC is composed of the FED Chair, 7 members of the Board of Governors, the President of the Federal Reserve Bank of New York, and 4 of 11 remaining FED Bank Presidents. These people come usually from the largest and most powerful banks in the USA as well as some leading Accademia.
Let’s go back to the FED formation and the history of this “Creature from Jekyll Island”. It was formed as a cartel of the big banks. It has been well over 100 years of the existence of the Federal Reserve System, but the beast is still a cartel of the biggest banks in the USA. FED yields enormous power of the cost (interest rates policy) and supply of money. It uses its power under the pretense of keeping “stable pricing”, a.k.a. control the inflation, and “full employment”, e.g. influence the unemployment level in the economy. However, the Central bank’s primary goal is to serve the interest of the Big Banks.
Many of you have heard the phrase “Don’t fight the FED, Go with the FED”. It symbolizes the reality that the power of the central bank is immense when it comes to economic expansion or contraction. Changes in the monetary policy can cause great expansions and also great recessions. The US economy has a tremendous amount of debt in the system, and the level of interest rates greatly impact what happens to the returns in the Stock Market, Real Estate, and many other sectors.
Monetary policy is one powerful drug that makes or breaks the economy. We all are forced to do business with the FED, the biggest drug dealer in the country. The FED has kept interest rates near 0% using the Zero Interest Rate Policy (“ZIRP”) since the 2008 crisis with the exception of trying to get away from the policy pre-COVID, but failed and were forced to return rates back down to ZIRP as soon as the Pandemic hit. ZIRP is a drug, a very powerful one, that got us all addicted to the “Easy Money”. Read the book “The Lords of Easy Money” to get a bit more color on the subject.
Everything I said here is widely known, it should not be a surprise to most of us. I am not advocating for the abolition of the FED. I don’t have a better solution to the problem that the banking system is very fragile and having the Lender of the last resort is critically important. The FED can take us out of the debt of an economic crisis, e.g. 2008 by printing a lot of money and setting the cost of money to be very low, via the ZIRP, and thereby stimulate the economy. But they can also damage the economy and hurt certain sectors tremendously when they are forced to withdraw the “easy money” policy.
Let’s take a look at what happened when COVID-19 hit us. The US Government went wild and printed money like there was no tomorrow, like the world was ending… Politicians love spending money and the pandemic gave them a powerful cause to do so. Of course, they overdid it, in a huge way causing an accelerating inflation. FED was sound asleep, too used to the ZIRP environment, claiming that “the inflation was transitory”. Maybe it was “transitory” and given enough time, and the end of government “helicopter money”, or aggressive COVID spending, the inflation could have come down naturally over time, and the end of government “helicopter money”, or aggressive COVID spending, the inflation could have come down naturally over time…
We will never know if the inflation could have naturally come down because the FED woke up one day and went wild, using the enormous power they control. FED chair, J Powell, executed the rapid ascend maneuver in the interest rates that was way “too fast and too furious”, hiking FED Funds rate from 0-0.25% to 5.25-5.50% from March 2022 to July 2023, about 1 year and 1 quarter. This was in the name of the “Inflation fight”.
The biggest problem of that maneuver was that the cost of money went up 40-50 fold, going from say 0-0.25% range to 5.25-5.50%. It is about 40-50X depending how you do the math. And the worst part was that it was very difficult to predict or to do anything about it for a lot of investors in certain sectors. Most investors understood that the FED was going to start hiking, but not how fast the Central bank was going to proceed.
Personally, I believe that the FED could have gone way slower and smaller and would have still achieved their goals. It would have taken a bit more time as long as the Government COVID spending was coming to an end. I think J Powell made a tremendous error going as aggressive as he did.
Now, let’s shift this whole conversation to the impact on the commercial real estate industry, and the harsh reality many of us are facing. Rapid rise in the interest rates has created a tremendous cash-flow problem for many commercial real estate “Value-add” projects that have borrowed using variable rate or floating rate debt. Wide majority of the “Value-add” projects had no choice but to borrow using floating rate debt as most lenders would only offer that product for non-stabilized properties. Large portions of the projects purchased in 2021 and 2022 are now facing a very harsh reality that they are in dire need of liquidity injection. Some projects purchased “Rate CAP”, a financial instrument policy that helped them mitigate higher interest rates, but most of these instruments were for 1-2 years, and are expiring, running out. Most banks are requiring the borrowers to obtain a new “Rate CAP” contract, which requires a large amount of cash. Furthermore, the commercial real estate industry has experienced tremendous escalation in the insurance costs across the country. Many insurance carriers pulled out due to losses out of certain markets, or implemented very large increases in insurance premiums. In some cases, these increases were as high as 300-400% if the property was in the natural disaster zone. But even the properties away from the high risk areas experienced often 30-40% increases year over year.
What’s really alarming is that there are many stabilized, perfectly good properties, that borrowed 5 years, say in 2019, have maturing loans. There is a significant talk in the industry about the “Maturities cliff”, simply tracking the fact that in commercial real estate, many stabilized properties can only fix the rate for 5 years. For example, many commercial loans are structured as 5 year fixed on a 25 year amortization schedule. In the extreme cases, interest rates could be fixed for 7-10 years, but it is rare. Once a property hits a maturity, it needs to refinance or extend the loan at the current interest rates, and that requires a large cash infusion. For example, property financed in 2019 with the 5 year fixed rate could see the interest rate reset from 4% to 7%, that is a 75% increase in the cost of the debt service. The only way to meet a bank’s required Debt Service Coverage Ratio (“DCSR”) is to pay down the principal of the loan, and that requires a significant cash infusion.
Now, let’s go back to many “value-add” projects. These include, ground-up construction projects, significant construction / renovations deals, redevelopment initiatives, and other strategies that can significantly enhance the value of the property through the work of the sponsor/operator. Many of these projects are facing big head-winds from the much increased interest rates, higher insurance costs, longer time lines to execute the “value-add” strategy, and other factors. Looking at a broad range of these deals, there are those that are already deep “upside down”, effectively these will become bank REOs via the foreclosure or a cooperative transfer from the owner to the bank. There are some projects that are “borderline” possibilities to survive as long as they get some bank relief in the form of forbearance or similar, and are able to raise additional liquidity / capital to get them to the finish line. Finally, there are properties that are fundamentally “great real estate”, and have a good chance to survive as long as they are able to raise fresh capital and get to the stabilization point.
The last category of the commercial real estate properties that has a good chance to survive and thrive in the upcoming years becomes a tremendous investment opportunity for the fresh money. Many of the existing investors on these properties are willing to support these projects, and new capital is eager to step in the form of the Last In First Out (“LIFO”) money. We have seen Sponsors and Operators issuing capital calls, asking investors to put in fresh money to support these projects. In some circumstances, the “capital calls” route can be viable. In many other instances, it is much better for the project to raise the LIFO money, giving existing and new investors an opportunity to invest fresh capital in a much better position on the capital stack, ahead of the previously invested money.
Why is LIFO the preferred method of fresh capital raising?
Let’s say you are an existing investor in a deal and you receive a capital call, and you decide to participate. What you don’t know is how many other investors will agree to participate. Quite often, the Sponsor can only raise say 50% of the capital needed via the capital calls, and then be still significantly short in the capital raising goals. LIFO approach solves that issue fairly and completely, it gives the opportunity to existing investors and if some of them don’t want to participate, then new investors can step in. LIFO money is senior to previous moneys and has the best “risk-adjusted” opportunity to earn a strong return, and indirectly these projects have a chance to get to the finish line, and recover previous invested capital too.
The most common example of LIFO investment comes as mezzanine financing or preferred equity that comes in between first lien mortgage (primary debt) and common equity investors. Just to be very clear, each project has to be underwritten and deemed worthy of the new capital to come in to provide the “liquidity support” in the form of mezzanine financing or preferred equity, with a strong business plan and the ability to execute it to get the asset to full stabilization within the target timeline. Once the asset is stabilized, the option of refinancing with long-term debt or selling the property should become viable. Careful underwriting is necessary to choose between the “worthy” and “not worthy” projects.
So, that leads me to discuss our best opportunity ahead. We realize that many investors in our community and all of the USA are experiencing anxiety, stress, and concern about their investments made in the last few years, primarily in 2021 and 2022. Why do I exclude 2023? Because it was a very quiet year, and transaction volume in 2023 was down ~ 70% from 2022. It is possible that some deals from early 2023 were bought badly too, but the few transactions that we entered in 2023 looked great and still do so – they were “bought right”. So, let’s leave 2023 year alone as interest rates were already high and properties were bought at the discount for the most part. These projects are most likely not facing the challenges the projects from 2021 and 2022, and earlier years are facing.
So, let’s dive a bit more into 2021 and 2022 (and some earlier years) purchased investments. Some of these are in the “blood bath” situation and not good targets for any rescue capital without major bank haircuts. Some banks may cooperate and some will not. But the real area of opportunity is this: great sponsors combined with the fundamentally great real estate that is experiencing liquidity pressure, but they have a clear path to full stabilization and have significant upside in that. Normally, great sponsors would have 1 or 2 “challenging” projects and many are just fine. Nonetheless, the rapidly increased interest rates are hitting many projects and all at the same time. High Interest rates act like a tsunami wave impacting many projects all at the same time. Even strong sponsors start running out of liquidity.
This creates a great opportunity for the “Tempo Advantage Fund”. The Tempo team is working to launch our version of this fund. This fund investment thesis is both very powerful from the risk vs. reward perspective for the new money and also it is the solution to many investments that raised capital through our ecosystem in 2021 and 2022, the worthy projects with the great sponsors. We believe that we will be able to provide great returns to our investments in this new fund via the LIFO investments in the projects that we already know as well as be opportunistic to diversify into new Sponsors and new projects that we underwrite to be worthy.
If you are interested to learn more about this “Tempo Advantage Fund”, please reach out to us via invest@tempofunding.com to be put on the waiting list.
