“At the same time that people like you and me are thriving beyond the dreams of any plutocrats in history, the rest of the country—the 99.99 percent—is lagging far behind. The divide between the haves and have-nots is getting worse really, really fast.”
This small quote came from a recent Politico article, wherein the author focused on the trees and pretty much ignored the entire forest. It’s not just this article. There’s been a lot of talk about the wealth gap between the rich and everybody else. Many people recognize the situation but few have a good explanation for it. After all, we were told that a rising tide lifts all boats, and now we learn that’s not always the case. How can that be?
The reason the wealth gap widens is due to the Fed driving down interest rates. Pushing interest rates down to almost zero (taking the money market yield as our reference) increased the wealth of those who already had assets and the hurdles for folks who wanted to acquire them.
By definition, the rich have assets, some of which might generate unearned income (a dreadful IRS term) in the form of interest, dividends and rents. The worth of these streams of income, adjusted for risk, is reflected in their capitalized value. Capitalizing streams of income at ever lowering rates increases the value of existing assets, benefiting those who already have them. This happens automatically, with no owner / management effort.
For example, given a $100,000 stream of unearned income and a market interest / cap rate of 10% – the value of that $100,000 would be $1,000,000 ($100,000 divided by 0.10). If interest rates ratcheted down to5%, the value of that same stream of income would double to $2,000,000 ($100,000 divided by 0.05). A $100,000 annual stream of unearned income, if capitalized at the recent 10 year Treasury note rate would be worth a little over $4,000,000. The formula is “net income divided by capitalization rate in decimals”. If market yields trend downwards then the values of existing streams of income elevate. It’s a simple capitalization rate issue: if rates go down, values go up.
On the other hand, lowering rates make it very difficult for a person who does not own income producing assets to accumulate the necessary down payment (plus closing costs) to buy a home. As interest rates decline, the value of the house appreciates so the (hypothetical) 20% down payment becomes a portion of an ever larger sum. Every time the required down payment is almost achieved, prices go up. That means fewer people can enter the market, but it also means that the folks who already own the assets have greater potential gains.
It is not valid to argue that, should the diligent saver somehow gather the necessary funds, she would benefit from low monthly house payments due to the present generationally low interest rates. What really happens is that houses are bought on a monthly payment basis. The average person doesn’t care if a $300,000 house is selling for $700,000 as long as interest rates are low enough that the monthly payments are still affordable.
And then when interest rates eventually normalize, as they historically do, she is under water. She can’t sell her house because the loan exceeds its then current value. Haven’t we seen this movie?
Sidebar: This example is fully applicable to apartments. If super low interest / cap rates mean a new purchase at $2,000,000 is reasonable today, what’s going to happen to its value when rates / caps normalize?
And that, at least in my mind, is the reason the wealth gap widens: the capitalization of pre-existing assets at lower and lower rates. People who enter a declining interest rate environment with income producing assets see the value of those assets climb. However, people who have no assets at the beginning of such a period will probably have no assets at the end … and there will be an end. Low interest rates can’t last forever. The wealth gap, after a transition period, will decrease as interest rates normalize. The rich will find their assets depreciating (i.e., meaning they are capitalized at a higher rate as interest rates rise) and everyone else will find the asking prices of assets they covet will be cheaper.
Sidebar: Normalized interest rates are defined for our purposes as that rate necessary for the investor to have an acceptable risk-adjusted return net of taxes and inflation.
Takeaway: Low cap / interest rates inflate wealth, but the cycle historically changes. When it does the wealth gap will narrow. That’s what I wish the author of the Politico article would have said.
Total Market Bubble
The financial press continues to argue that we are not in an economic bubble. Not all the commentators, but most of them, seem to base their position on the fact that yield relationships among various asset classes remain approximately in place. The argument is that as long as these traditional yield relationships continue fundamentally unchanged, by definition no bubble can exist. It is true that yield relationships are important, but the silent second part of that sentence is “. . . until they’re not.”
As illustration only, let’s hypothetically assume that the dividend yield on a well diversified basket of common stocks exactly matches the ten year Treasury bond. The yields correlated when the market interest / dividend rate was 9% and they continued their orderly connection as interest rates were perp-walked down to 3%. If the dividends were unchanged, the value of common stocks originally paying 9% would be priced about three times higher at a 3% yield. That is a huge gain. The financial press, however, argues that this does not constitute a bubble because historically normal yield relationships continue to prevail among asset classes. If relationships are normal, they ask, where is the bubble?
There is, I think, another way to look at it. What if there were no asset class bubbles (plural), but there was a single market wide bubble which includes all rent-dividend-interest paying asset classes? That might explain what we observe, including the consistency of yield relationships. Lowering rates raise all boats equally.
But only a puppy’s love is forever. The essence of “bubbleness” is fundamental non- sustainability. Social media stocks could be in a bubble (i.e., their values might not be sustainable on fundamental measures) for example, and most if not all financial observers would quickly recognize the fact. It’s like an Iowa farmer looking over the back 40 and seeing a single corn plant that’s three times the height of the other plants. “Dang,” the farmer says, “that’s a big ‘un”. A single over-tall corn plant is obvious. A single asset class bubble is just as obvious because, like that single corn stalk, it violates historical relationships.
But it’s harder to recognize when all income producing asset classes are bubbling together, especially if their yield relationships maintain traditional levels. If all the corn plants were unexpectedly tall it would be difficult to recognize that something might be amiss. “Martha, you oughta see them corn plants! Musta been the rain we had last night.”
From this wider perspective, there may be no specific identifiable asset-class bubble, but that doesn’t mean the whole caboodle isn’t inflated beyond all pretense of sustainability.
Presently, we know that (1) cap rates are seriously low and consequently (2) nominal asset values have never in our lifetimes been higher. We know these elements are related and that low caps automatically raise values, just as rising cap rates depress values. Investors have rarely been asked to pay more for a stream of income than they now are. Earlier this summer a well located apartment building was advertised at a3% cap rate on projected income. (No identifying data provided because there is no wish to embarrass the twit who listed it.)
“Golly, Mr. Buyer! Its so-o-o cute and it’ll make a great investment. There’s plenty of upside! And as the years roll past if you can raise the rents enough you’ll get a3% cash flow. Once you pay off the building, of course. You said you wanted retirement income!”
Since yields determine value, it seems the better (“better” as in more likely to protect capital) way to look at the current economic situation is to estimate values in a normalized rate environment. If the value of a stream of income will be lower (example) at a 9% cap rate than it is now then the arc of the investment is declining. It may be time to harvest the corn.
Forming an opinion on where we might be in the economic cycle is important because if we think we might be approaching a tipping point our job would be to preserve capital during the transition. If we don’t believe that to be the case then our job description would continue to be growing capital.
The question, then, is preservation or growth? In arriving at a supportable judgment there are a number of factors that probably should be considered. We’ll end this article with a brief discussion of three of them.
Some economic events require both time and treasure to rectify. If it takes time but not treasure, it is called winter. Wait a bit and spring will arrive. No money is required. An example of “winter” is the lease-up period of new construction. Consider: a 50 unit apartment building is just getting its Certificate of Occupancy, and the buyer understands that in the current market it might take three years to stabilize the income. It will clearly take time, but no additional net treasure because projected lease-up costs are built into the purchase price.
- · If we think interest rates might go up but it will only be temporary and they will soon return to the current level, we might buy on the dip.
If it takes treasure but not time, it’s called an expense. Pay it and move on with life. A tenant learns that the unit you’ve been renting to him for the past 11 years is not really a permitted living area. He sues for recovery of all 11 years of rent payments. The judge is considering this. If it happens, it’ll be an expense requiring treasure, but no time.
- · If we think interest rates will go up moderately and probably stay up, we might (a) refinance to get a longer fixed rate term, and / or (b) pull cash out so we’d be able to buy when rates climb and prices moderate.
If it requires both time and treasure it’s a Serious Economic Event because solving a multi-variable problem is more complicated and false starts can alter the relationships. Example: Hidden constructiondefectsarediscoveredinthatnew50unitapartmentbuilding. The building is red tagged. Units can’t be rented until the deficiencies are corrected. That takes treasure, and with new permits and revised lag time the building won’t be generating in come for a lot more than the budgeted three years. The thing is there is no robust way to credibly forecast the consequences of even most two-factor Events.
- Should we believe inflation will increase and interest rates follow, which might in turn cause inflation to further increase and interest rates to further follow until an economic disaster looms, we have at least a two and perhaps a multi-factor event. Please say you don’t forecast this, because from today’s perspective it doesn’t look very probable.
But if a person were going to make investment decisions based on the stakes rather than the odds, this could turn out rather well for people who own apartments going into the disaster. After all, he’ll be paying off the loans with inflated – possibly very inflated – dollars.
The most likely future, in my mind, would certainly not end in disaster but would include more than two variables, as in many urban / suburban areas today. Consider an environment where (a) large new apartment projects are going up almost everywhere, where (b) official inflation numbers lack credibility, (c) interest rates are expected to rise, and (d) layoffs (or a reduction to 29 hours weekly) are increasing even among large employers. This would be a four factor event, and each factor compounds the difficulty of the solution. The most likely outcome becomes a moving target. To really address this fully is beyond the scope of this short column. But briefly, one way might be to estimate the possible costs (in treasure and in time) of each element and then to develop contingency plans for as many of them as might be reasonable.
Not in any particular order, but increasing interest rates might not be quite as critical if the underlying loan remains favorable. A loan with a long fixed rate period at an uber-low interest rate and an adjustable period with a life-time cap of 8.5% would be a blessing, although such things are realistically “unobtainium” in the current market. The bankers aren’t fools. They, too, see a variety of market complications when they peer into the future and adjust their loan offerings accordingly. But life-time caps under 10% are still available.
It’s very hard to work up a credible estimate of future inflation, but one way the private party might approach the challenge is to subtract the yield of the inflation-protected TIPS from a similar non-inflation protected Treasury bond. The difference is the market’s expectation of inflation (a) over that period and (b) at that moment of time. Don’t use the yields directly from fresh Treasury auctions. You’ll probably get a better accounting if you compared seasoned bonds that sell on the secondary market. These are normally less sensitive to official inflation figures. Probably a person would wish to use bonds whose remaining life corresponds with the term of the inflation sought. Example for a 27 year estimate: If the 30 year traditional bond with 27 years remaining sold at a yield of 7% and the equivalent TIP sold at a yield of 3% then one could conclude that the market forecasts a 4% average inflation rate over the next 27 years.
Increasing competition (new construction) and a diminishing tenant pool (layoffs) are financial problems. Since they both could result in higher vacancies they would probably be handled in much the same way. In the past reduced demand has sometimes been ameliorated by encouraging roommates, if necessary. No other adjustment the landlord could reasonably make impacts the tenant more positively than a 50% reduction in rent, unless it’s allowing four girls to share a two-bedroom unit. That would be a 75% reduction in per capita rent.
Takeaway: Based on future normalization of interest / cap rates, we appear today to be in a total-market bubble. That’s why prices of income producing assets are so high, regardless of asset class. The future will probably bring a confluence of economic events that will jeopardize the viability of some (but not all) investments, even those that seem to be doing quite well right now. In reference to apartments, thoughtful contingency planning regarding increased competition, diminished tenant pool, higher interest rates and increased inflation may be indicated.
Disclaimer: Thisarticleis forinformational purposes only and isnot intended as professional advice. For specific circumstances, please contact an appropriately licensed professional.
Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email Klarise.Yahya@Charter.net.
If you’ve missed some ofthe prior articles, basic beginner guidelines on successful investing are in my book “Stairway to Wealth” available atwww.LuLu.com .