Spring Season is upon us here in the Northern Hemisphere, but the economic weather is not getting warmer. Instead, it is looking more volatile now with both raging high inflation dominating media headlines and the quiet talk of an upcoming recession.
The FED was sound asleep at the steering wheel for too long, but they woke up in March 2022 and set very aggressive expectations of many interest rate increases this year in order to fight the inflation, as well as reduce their balance sheet, which implies selling treasuries in the open market or not buying new ones that mature, likely pushing interest rates up along all spectrum of the yield curve (short to long maturities). The yield curve technically inverted on April 1st, with the 10-year treasury yield being 2.39% and the 2-year treasury rate at 2.44%. And that is a technical leading indicator that many experts look for to predict a likely recession in 6-24 months after that event.
One thing that is highly probable now is that the FED will accelerate its interest rate increases to slow down the accelerating inflation. Given March reported inflation of 8.5% from a year ago, it is almost a certainty now that the FED will increase its target rate by 0.50% during its May meeting and will proceed with a plan to start shrinking its balance sheet and continue projecting many rates increases in 2022 and beyond.
This anticipated FED action plan can have a few unwelcome outcomes:
A) Economic Recession: slow or negative economic output growth (very slow or negative GDP growth and high unemployment)
B) Stagflation: high inflation combined with high unemployment and slow growth. Economic recession combined with the high inflation environment.
It is almost unreal to be talking about an Economic Recession or Stagflation on the horizon when the US Economy is running red hot today and inflation is almost out of control.
It is important to acknowledge the fact that the rapidly increasing interest rates will slow the economy down for sure, but it doesn’t necessarily mean a full-scale major recession is coming imminently. We live in a bit of an unprecedented time with Covid disrupting a global supply chain that has never been seen before, and therefore, many past trends and patterns may not exactly hold today the way events took place historically. Nonetheless, rapid interest rate increases from a very low point are extremely damaging to the economy because of the immediate and relatively heavy impact on the cost of the debt service they create. It is not about the rate increase on absolute terms, but rather it is all about the relative cost to the borrowers that these increases create. For example, the cost of borrowing for Single Family Residential (SFR) investment properties from most of the large portfolio lenders has gone up from under 5% to around 7%, 200+ basis points over a period of about 30-40 days. That is effectively a 40% increase in the payments on those mortgages. Similarly, debt service under most Lines of Credit (LOC) and other variable rate products linked to short-term interest rates is similarly up by 30%+. That is a massive change over a very short period of time. And obviously, there are more increases coming. The real danger is that the FED is acting on the data coming from the past, and the current interest rate increases may slow down inflation for many months out. And as a result, by the time they are done with the interest rate increases the economy might very well be in recession. This has happened multiple times in the past and probably will happen again.
So, what moves can a prudent investor make today that can help weather the potential economic Winter storm?
Let’s talk about the high-level strategy here. Rapidly rising interest rates are extremely painful to bond investors, especially when the rates are very low to start with. If you have been invested in bonds, you have already taken it on the chin, but the beating is not over. It just started. Perhaps, now is the time to exit most of the bond investments (or bond funds) as quickly as it makes practical sense. Bonds do terribly in high inflation and rising interest rates in the environment in general.
Stocks aren’t happy about the rising interest rates either, especially the companies that have heavily leveraged balance sheets, or those who don’t have a big customer install base to increase prices during the high inflation era. Another really important concept is that the US Government bonds are perceived to be “risk-free”. As rates rise, the returns in higher-risk investments just look less and less attractive, as investors can deploy their capital without risk into the US Government bonds per say. This concept applies to many equity investments that have a substantial degree of risk. Most interest-rate-sensitive stocks and mutual funds don’t look attractive at this stage of the game.
Now might be a good time to re-balance an equity portfolio and move a portion of the capital into alternatives, such as Real Estate. But I am not talking about diving into public REITs (Real Estate Investment Trusts), although these investments might have a place in a portfolio. What I have in mind are private Real Estate Investment funds and syndication’s, carefully selecting the best fund managers and operators, and the best products available to investors.
Before we dive into these Real Estate investments, let us first discuss some of the basics of the portfolio management to protect against the likely risks ahead:
1) Review your portfolio goals:
– Risk / Reward tolerance
– Cash-flow needs
– Risk-Adjusted return target
– Tax Efficiency
– Time Horizon
Obviously, life events drive changes in goals. For example, making a decision to retire in say 2 years should impact multiple elements of the portfolio composition, lowering the risk, increasing cash-flow needs, shifting the time horizon of certain investments, and adjusting for the likely tax liabilities in retirement. It is prudent to periodically reevaluate your portfolio and its goals even without life events. Consider going through that exercise now.
2) Re-balance and further diversify: Investments that have run up a lot become good candidates to sell or partially sell, moving the capital into investments that are less volatile, more defensive, and more predictable. The concept applies to Wall Street investments and alternative investments too such as Real Estate. In Real Estate, there are many hot markets that have outperformed the steady-eddie markets, and the play today is to diversify out of the highly appreciated assets into more predictable regions of the country that generally withstand economic volatility well. For example, hot markets like Phoenix, Las Vegas, Southern CA, or FL, look a lot less attractive today vs. some of the real estate investors’ friendly markets in the Midwest.
Re-balancing out heavily appreciated, but interest-rate sensitive stocks into defensive Real Estate investments is another idea that makes sense today. Look at broadly diversified Real Estate funds as a mechanism to quickly achieve broad diversification and risk reduction.
3) Invest with people you know, like, and trust, and into the projects that make more predictable and less volatile returns in any market. Most investors want to sleep well at night, especially in a down market. All investments have risks. But investing with people who know how to manage risk, especially in a down market, can make a big difference in the results. Project selection is also critically important. Selecting projects that are more of “Investment Grade” with more downside protection rather than “Speculative Grade” is critical going into a down market.
Now, let’s shift our focus into the discussion of what Real Estate Investments make good economic sense today, looking into a rising interest rate environment, with the risk of a recession on the horizon.
Affordable or workforce housing projects present a very attractive, downside-protected sector of the economy, given that there is a massive shortage of affordable housing and strong demand for it. We love the strategy of hotel conversion to workforce multifamily living. The cost basis of these conversion projects is typically substantially lower than the reconstruction cost. These assets cash flow well upon stabilization and are very finance-able. This strategy should perform well in a recession.
Next, we really like Class “B” light value-added multifamily investments in the steady Midwest markets, especially with the partners who have a large footprint in specific markets with a strong execution capacity. The ability to execute renovations at a good pace, while maintaining at least the break-even cash flow, makes all the difference. These projects purchased at a very attractive cost-per-door basis have strong downside protection and can generally withstand a typical recession.
Self-storage continues to be an attractive sector of the economy that generally does well during recessions. However, the deal selection is critical as many markets have been over-saturated with supply. Light value-add, better management, and better marketing opportunities are much more attractive vs. ground-up projects that have major development risks.
Distressed and performing conservative LTV hard money loans is an asset class that should do well in a down economy too.
There are other “defensive” strategies out there. Investing in Preferred Equity rather than Common Equity is a way to reduce the risk and have a higher degree of safety while capturing a decent level of the project upside too. For example, Tempo Growth Fund II, LLC offers investors two classes of units: Preferred Equity Units and Common Equity Units. Preferred Equity units have the seniority of the cash flows as well as the priority of the return of capital, while still capturing 30% of the portfolio upside.
In summary, prudent investors today are selling highly appreciated assets in speculative markets, repositioning the cash into more conservative assets, steady markets, look into investments in preferred equity to increase safety while maintaining strong diversification.
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