Real Estate Investing in a Rising-Rate Environment

With interest rates headed upward yet again because of the latest round of belt tightening by the Federal Reserve, and the stock market falling with no bottom in sight, many people are crying doom and gloom.

I hear talk of watching for a rise in foreclosures because of stock market losses. Builder friends are convinced they are about to be ruined. In my opinion, this is no time to rush for the exits. The fundamentals of real estate investing are sound. A short history lesson may prove worthwhile.

My experience goes back to 1980 – 1982, when I was a single-family home builder. Now that was tight money. With prime in the high teens, very few deals made any financial sense for lender or borrower.

Then came the five years of favorable tax treatment that made dumb and dumber deals look good–until Congress pulled the plug on passive losses. Then we had to re-learn an old lesson: If it doesn’t cash flow, it’s not a deal. The recession of 1990 – 1991 was a cakewalk for those who weren’t over-leveraged. I wasn’t one of them and paid dearly for the mistake.

Fast forward to 1998–we were riding what has now become the longest economic expansion in history. Asia went ape, the Russian ruble turned to rubble, and the markets taught a physics lesson: What goes up, does come down.

The Fed cut rates, everything settled down, and for the most part it was business as usual on Main Street. But for the first time we got an “up close and personal” look at how interconnected this global economy has become.

How do we plan for the next ten years?

Now, it’s the year 2000. Y2K turned out to be a non-event (though it took the blame for a general slowdown in activity in fourth quarter 1999). Gas prices are at record levels, yet spending remains strong. Why? Are we heading for recession? Does it matter? How do we plan for the next five or ten years?

One fact remains constant for the real estate industry. Our health and well-being have always been tied to the availability and the cost of debt capital. That is to say that as long as we as investors have access to reasonably priced financing for our properties, we can survive in any market.

I learned in 1991 that it wasn’t enough to have equity; property has to cash flow as well. And I learned that when I can present my company as a stable enterprise, insulated from the uncertainty of highly speculative investments, lenders will roll out the red carpet for my deals.

Always follow the money

If then we are dependent on debt capital to fuel our operations, it is important that we as investors understand what influences and moves the markets in way that affect the cost of our funds.

The first thing to know when listening to the “gloom and doom” reports in the media is that reporters have little knowledge about any business other than reporting what people tell them is important.

When they report the Dow Jones Industrial Average (DJIA), they are using the implied credibility of a well-known financial measuring stick for a good news/bad news sound bite under the assumption that you know what it means. Most of us don’t.

The DJIA is made up of thirty companies picked to represent a cross section of the economy. To put that in perspective, there are 3090 companies listed on the stock exchanges (NYSE, 771 on AMEX, and over 6500 on NASDAQ). The DJIA companies represent approximately one-fifth of the value of all US stocks, and about one-fourth of the value of the stocks listed on the NYSE.

This “average” isn’t designed to predict anything, but rather to track the general trend of where the market has BEEN. Trying to gauge where the economy is headed by watching the stock market is much like dressing for Alaska knowing only that it has an average temperature of 55 degrees. The result, as Nobel-laureate economist Paul A. Samuelson put it, “The market has predicted nine of the last five recessions.”

But the market is an indicator of the collective perceptions of the investment world. When political turmoil hits, as we saw in Asia and Russia in 1998, money will flee quickly to safety and liquidity. Money doesn’t care who owns it, but it despises instability and uncertainty. “Tight credit” is another way of saying “minimize risk.”

Stocks carry risk, and therefore when things get dicey, money moves into low-risk investments, causing the price of stocks to fall. The present tech stock fallout is another indication that the market perceives the risks to outweigh the potential rewards.

Conversely, as the low-risk investments (namely government bonds also known as T-bills) come into higher demand because they are safe and liquid, the price of those bonds will rise. As the price of a bond rises, the yield drops.

Many commercial and residential mortgage loans use the yield of government bonds (or T-bills) as the index for the interest rate charged on the loan. The interest amount over the index rate is known as the spread, generally quoted in basis points (100 basis points = 1 percentage point) over the index rate.

This is the element of commercial lending that falls into chaos in a scenario like we witnessed in 1998. Again, a lesson from our recent past can best illustrate the point. As the benchmark 30-year and 10-year T-bills soared to record prices, the yields dropped to record lows.

Lenders, especially the conduit programs for Commercial Mortgage Backed Securities (CMBS) on Wall Street, were caught in a classic squeeze. They had untold millions of dollars committed at spreads agreed upon months earlier with no warning of any trouble on the horizon, and were faced with funding these commitments at interest rates below their cost of funds.

The market took six months to readjust, and spreads have returned to manageable levels. But the most interesting development to the Wall Street debacle was the way commercial banks and credit companies moved quickly to fill the void. Since the waves in the market were not from any instability in the collateral, i.e. real estate, the money became available from other sources.

In short, the markets corrected the inefficiencies, and money flow resumed when certainty and stability were again in place. What does this mean to the average real estate investor? It means money continues to be available for deals that make sense. That rates are a tick or two higher will not make a strong deal weak, or a weak deal undoable. It must make sense.

So how do we determine which investments actually make sense?

Main Street vs. Wall Street

The fundamentals of the real estate industry have not changed. The Wall Street players, and the relatively recent use of the CMBS to capitalize real estate, have not captured so much of the market as to control access to debt capital. Commercial banks, insurance companies, and to a certain extent pension funds, are still the mainstay of real estate funding.

However, some sectors of real estate are going to be harder to finance due to the effects of other market factors and may be best left to those players big enough to weather the storm.

Hotels, for instance, have been on the brink of overbuilding for the past two years, and the alarm was sounded for a slowdown in room growth completely independent of the global financial problems or the cost of oil. This is not to say that there will be no hotels built for the next year. But the ones that are built will most likely have a strong franchise, a killer location, and a verifiable market.

In short, the deal will make sense from a hospitality business standpoint, not as a speculative real estate project.

One side note on oil: We must be aware that this one commodity has the power to move our markets in ways we don’t even fully fathom. Being in the hotel business, I watch the price of gasoline for the obvious effect it has on travel. I started getting nervous last December (1999) when prices topped $1.40, and no one was saying anything.

In mid-January (2000), OPEC intimated it would vote to increase production at its spring meeting in Geneva, but that the increase would be too late to affect prices during the summer travel season. I was still concerned, but relieved that OPEC was not going to take a hard line ala 1973.

Then the media, in its usual clumsy manner, finally noticed the price of gas in late March (2000) and sounded the alarm. Mind you, the problem was already solved, and now the media and the government wanted to get in front of the crowd and take credit for fixing a problem they hadn’t even noticed until it was over.

Some say the clumsy handling and belated pressure from Washington actually made it harder for OPEC to do what they had already planned to do, lest it look like they were caving into pressure from the US. I get nervous when government actually acts. I’d much rather see gridlock.

Watch the right numbers

For the market as a whole, the base demographics that real estate relies on remain solid. Looking at the industry through the lens of a few select property types can offer insights into where we are headed in general, as well as highlight specific islands of opportunity.

Mobile Home Parks remain strong, and in fact, they are category killers when it comes to valuations. The Real Estate Investment Trusts (REITs) have scarped up most of the investment grade parks, and are now homing in on the larger parks of B and C grade to soak up the cash being made available.

This serves to drive up the valuations of formerly unattractive parks, and ever-restrictive zoning standards across the country combine to give this property type one of the highest potential returns available in real estate.

The demand for affordable housing continues to grow, and mobile home sales are predicted by the Manufactured Housing Institute to continue to comprise about 30% of single family housing sales.

Commercial growth and development remains strong. Reacting to a perceived threat from Internet sales, traditional retailers have found they can compete in a hi-tech, hi-touch environment, and that Online activity in fact boosts in-store sales.

Online spending has in fact created a mini-boom in warehouse and distribution facilities. Commercial occupancies reported to the International Council of Shopping Centers are averaging in the nineties. Retail spending remains strong.

Consumer credit, while higher in dollar amounts, is in fact the least we have seen in recent years as a percentage of income. The income and employment levels of the population as a whole are the strongest in history, which in turn drives spending, and are the key indicators for the near term economy.

The National Association of Home Builders predicts single family housing starts to fall somewhat in 2000, but still average over 1.3 million starts, more than double the starts in 1982, and 50% higher than the 840,000 starts in 1991. This is good news for rental property owners without being bad news for builders.

Apartments have both permanent and bridge financing products available to fit almost any scenario. Rates can range from the mid 7% range to a point higher in most parts of the country. Debt coverage ratios on even marginal properties are in the 1.15-1.25 range, certainly not an indication of overly tight money.

Rents are rising faster now, due in part to rising residential mortgage rates, which are cooling home sales. Occupancies remain strong as a reflection of the record low unemployment rates we have enjoyed in the past several years.

These are the fundamental demographics that control our industry. In short, if a deal is really a deal, it will make sense on these factors, and it can be funded and profited from, global financial hiccups and market swings aside.

The Roaring 2000s

I recently read a book titled The Roaring 2000s, by Harry S. Dent. In it he predicts that the greatest economic expansion in history will occur in the first decade of this new century. He bases his predictions on the population curve and spending patterns of the baby boom generation, and a multitude of other long-term trends that are operative in our economy.

I tend to agree with his analysis (and highly recommend the book) and believe that some of the highest appreciation gains in real estate ever seen will occur in the next eight to ten years. Now is the time to position our income real estate for maximum valuations.

That means making capital improvements with the cheapest money we can find and raising rents on the strength of the completed improvements. Take this opportunity to examine service contracts, evaluate expense trends, and check utility consumption. If you’re looking at an acquisition, make sure it makes good business sense.

The formula for growth now, as in the past, is: “Create stability to attract funds.” Remember that lenders are in the business of loaning money for the purpose of gaining a return, and they’re counting on us to bring them deals that make sense for all parties.

Unless the world can solve Asia’s debt problems, bring political stability to Russia, hold up the weather in Mexico, and turn the Eurodollar into the United States of Europe, all in the next year, there is nowhere else but the US for world money to hide. And once it gets here, it won’t be happy with a 4.5% T-bill yield for long.

Will we be ready? Will we have the product available to invest in when the time comes? As the market weeds out the uncertainty, good deals will get better, and the quick will reap the profits. I intend to be in front of the line.

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