This article was posted on Friday, Apr 01, 2016


Executive Summary: For purposes of this article, a declining interest rate environment (the “back half” of an interest rate cycle) is the rising tide that benefits investors as a group. This is the period that investors live for. Net operating income goes up every year, seemingly with very little customer resistance. Payments on variable rate mortgages shrink as rates decline. Investment values go up, apparently automatically. This is the clement investment climate that it looks like we may be coming out of. Sigh. 

For the most part, a secular decline in rates indicates an economy requiring stimulation. Notwithstanding, if starting from an unusually high interest rate level (i.e., the early 1980’s), ever-lowering rates can support an economy for a long time. The transition to deflation happens when economic growth turns negative in spite of low interest rates. In that environment all but the very few prepared investors will struggle.

The front (rising) and back (declining) portions of an interest rate cycle are not symmetrical. Usually, rates go up faster than they come down. When rates are going up it is time to be patient. The well positioned investor can choose to wait until interest rates are seen to be peaking (and prices bottoming) before returning to the salad bar.

Overview: There has recently been much discussion in the economic press regarding deflation. Deflation is certainly rare and in many ways unique. It is below-zero growth. It is when an ever-increasing population shares an ever-decreasing pie. This gets the ruling class’s attention really fast because serious deflation can be politically incendiary. Credit obligations taken on during times of prosperity remain, as do the payments. But the values of assets bought in earlier times drop, and remain underwater even with uber-low interest rates. The velocity of money declines. There are fewer jobs. Rents go down. While deep deflation may be a godsend to those few with investable cash, it can be a disaster to those who are over-indebted. Unlike inflation, where a rising tide lifts all boats, in the very rare times when deflation strikes the entire economy ebbs.  

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The government takes every reasonable step to avoid, manage, and eventually recover from deflation. All these efforts revolve in some way around economic growth, because a growing economy is (by definition) not deflationary. Generally speaking, there are two fundamental ways to stimulate economic growth: either monetarily or fiscally. Monetary policies are established by the Federal Reserve’s seven-member Board of Governors and control interest rates. The Fed is a one-trick pony.

Fiscal policy is reflected in tax levels. Trying to fine-tune taxation, what with all the lobbyists and the House and the Senate and the Executive branch and all their assorted minions, hangers-on and sycophants each fighting for their own favorable carve outs, is slow and ultimately uncertain. Except for very unusual circumstances, managing inflation through fiscal means is pretty much off the table. And that is why those seven Fed Reserve governors are given the chore. The pony may have only a single trick, but he reliably produces that trick on demand. 

Deflation is insidious. By the time its harmful effects become obvious it’s usually too late for the investor to protect her assets. That’s important: if we wait until deflation is fully manifest, it’s too late. So the investor usually has to act before all the data is in.

The interest rate cycle: We’ve all seen historical interest rates diagramed on a graph. There’s the level horizontal blue line in the middle of the page representing the long term average. Then there’s the red line of actual historical rates cycling around the blue line, sometimes above and other times below. Rate changes are plotted on the vertical Y axis. Rates higher than average are above the blue line; low rates are below the line. Time is indicated on the horizontal X axis.

A complete interest rate cycle contains both the period of increasing rates (the “front half”) and the time of decreasing rates (“back half”). The inflection points are seen only after the fact, when a period of rising rates changed to declining or alternatively when low rates began their upturn.

Commonly, most investors make the largest part of their money during the back half of the cycle. This is when interest (think: capitalization) rates are in a long term decline – sometimes of a decade or more – and lowering cap rates make an investor’s stream of income increasingly valuable. When rates are in a long term decline it means that investment values will be in a corresponding uptrend.

Investors who enter the back half (declining part) of the cycle with at least some assets, even if it’s only their single family home, have the potential to prosper. As rates decline the home becomes more valuable. Eventually it can be refinanced (“Why not, Martha? The payments will be exactly the same and we can pull out a couple hundred thou’?”). The cash-out makes the down payment on a small apartment building. Rates continue to decline and a few years later the investor refinances his small apartment building and buys another. Repeat as needed. A reasonable alert investor can make much money during the back half of the interest rate cycle.

The most recent example originated in the mid-1980’s when interest rates began a 35 year decline. Imagine, back then, a 10 unit apartment building in a decent area with each unit renting for $200. The NOI might have been $15,000 annually. Capitalized at 12%, a building like that would sell on the market for about $125,000.

Now, thirty five years later, its NOI has compounded at 5% annually and is now at $83,000. If this number was capitalized at a hypothetical 4%, the market value of that 10 unit building would have grown to $2,000,000.

Interest rates are still very low, well below their long term average. While they might go lower still, it’s not unrealistic to anticipate rates will eventually trend upwards and it might, just might, be time to prepare. Remember the Wayne Gretzky dicta: “Skate to where the puck will be”

If the investor has managed her mortgage(s) properly during that three-plus decade of lowering rates she’ll have one or two buildings that should be refinanced. For a variety of reasons, of course, not every building is a candidate for refinance, but some are. The last time rates were this low many of us were still living at home. We’ll probably not see these interest rates again in the remainder of our investment career.

I have a crystal ball, but it was bought used at a thrift store and there’s a big crack right through the middle so at any given moment I can only hope to see about half of the issues. Nonetheless, my crystal ball says that the net funds received from a refinance should probably be reserved for opportunities that may come up in the future, after rates have risen. Higher interest rates might generate some remarkable bargains. 

As we enter the front half of the next cycle, whenever it happens, interest rates will start to climb and values drop. Those buildings the investor refinanced at the top of the market will be underwater – even the one or two refinanced in the last paragraph – but it’s a paper loss. It is not appropriate to clutch your pearls. Your cash flow is still there. The tenants are still paying off your (latest) mortgage. And you’ve got that re-fi money in the back of your unmentionables drawer, just waiting for the perfect property at the perfect price. While you’re waiting it’s probably best to nibble on cucumber sandwiches and calmly sip a bit of tea while watching reruns of Downton Abbey. 

Probability:  Last month and this month we’ve been discussing William Bernstein’s four “catastrophic losses”, one of which is deflation. It may happen, but it’s far from certain. We’ll see in a moment how very unusual it is.

 The economy is elastic. Some families are always moving closer to Nordstrom’s while others begin to search for a used single-wide. Due to productivity increases and inflation, historically more people gain purchasing power through the years than lose.

There has only been one time during the last 50 years when annual deflation (the dollar buys more) was noted. In 2009 shows the purchasing power of the dollar increased 0.34%. That’s one-third of one percent. Only the wonks noticed. Clearly, deflation is not a high probability event.

Severity:  It’s not totally appropriate to be comforted by a one-year-in-50 deflation rate. After all, as they say, “this might be the year”. A more actionable metric is to watch the direction of interest rates. That should tell us what concerns the Federal Reserve. If rates trend upwards (significantly above that blue line on our graph) the Federal Reserve anticipates inflation, because rising rates are supposed to cool an over-heated (inflationary) economy. If rates decline, the Fed is forecasting deflation. Declining rates are supposed to reinvigorate the economy (and, during the past 50 years, they usually have).

In 1982 rates for the 10 year Treasury note were 13.92%, and dropped from there to 1.8% in 2012. (They were 2.14% in 2015.) A credible argument could be made that the first part of the decline, from 1982 to 1999, when they reached their long term average, was a reaction to the tight money of the early 1980s. But rates didn’t stop at their 1999 level of 5.65%. Treasury rates continued their decline and have remained at sub-average levels since 2000.  That is a large part of an entire generation. The trend line shows we have spent 16 years watching the Fed’s single-trick pony try to pull our economic wagon. It continues to be a work in progress. That illustrates the difficulty of reversing deflation, should it happen. In the interim, it’s not the probability of deflation that is important, it’s that the consequences could be dramatic. Once again, it’s the stakes, not the odds.

Discussion:  As you would expect, major beneficiaries of deflation would be those (few) people who have the wherewithal (and the fortitude) to buy at high interest rates and historic low prices. It’s not quite the same as owning apartment buildings, but just to illustrate another example of buying at serious lows, if you owned one share of GE stock on October 28, 1929, available at the time for $222, it would now be worth over $28,000 (adjusted for splits). After adjusting for inflation, the purchasing power of that single share would now be $3,077. You would have multiplied the purchasing power of your principal almost 14 times, all while cashing your dividend checks. Deflation lowers prices, and buying at low prices can be a seriously good thing.

But not everybody will be equally affected. For example, an investor who had income producing assets as the earlier period of lowering rates began (or bought reasonably early in the decline) grew her net worth. That can quickly be illustrated by simple capitalization (net income divided by cap rate). An annual net rental income of $50,000 capitalized in 1999 at 5.65% was worth $885,000 at the time. If the income stayed the same, by 2015 its value (capitalized at 2.14%) was $2,336,000. That is a growth in principal of 6.25% compounded annually over 16 years, due simply to the Fed’s attempt to manipulate deflation through interest rate management.

If that $50,000 net rental income was increased by 5% annually it would have turned into $109,000 by 2015. That sum capitalized at 2.14% indicates a principal value of a little over $5 million.

At a very basic level, declining interest rates (the back-half of the interest rate cycle) benefit investors. One way is by increasing the capitalized value of existing assets as interest rates decline. Another way is if even very low rates no longer motivate economic activity and the economy slips into negative growth. In the latter event, formerly pricey assets become available at friendlier prices. That’s the moment when foresighted investors (who haven’t spent their re-fi money) might be grateful they’ve positioned themselves where the puck is.

The last of Mr. Bernstein’s catastrophes is devastation. 


Think of devastation as sudden loss by natural cause, not by regulatory action. We’re not talking about Kelo vs City of New London  (eminent domain: see below) here. That being the case, most (but not all) devastating losses can be insured against.

Example:  Examples of devastation include the risk of fire (for which the lender will require insurance to replace damaged improvements). Other examples might include earth movement (hillside erosion, earthquakes), wind (storms) and water losses (floods, unusually high tides, burst mains).

Probability – These are relatively improbable events, as evidenced by their insurability. When an insurance company is willing to write a loss policy at an affordable rate it’s pretty clear that most people are not expected to experience the named loss in any given year. Even very high payout policies can be purchased at affordable rates if (a) a lot of policies are sold and (b) the insurable event is rare. The issue to the property owner, of course, is not that loss might happen. It is that if it does happen, the loss may well be catastrophic. As always, it is the catastrophe itself we’re insuring against, not the likelihood. Think stakes, not odds.

Severity – To recover from devastation may cost more than the property is worth. Conceivably, property loss could exceed the combined value of the existing land plus improvements. Consider the possible remediation costs if toxic chemicals were maliciously poured throughout the property by a distraught tenant. I read somewhere that removing the toxicity is the legal responsibility of the current owner, not necessarily the fellow who owned the property when the toxicity occurred. The bill for restoring the land to utility could be enormous.

Discussion:  Probably the most likely people to benefit from an owner’s devastating loss (earthquake, fire, storms) are the people who can repair the damage better (or quicker, time being money) than she can. Think of uninsured earthquake losses. Immediately following the 1994 Northridge earthquake, small general contractors with existing crews began almost immediately to repair many of the damaged improvements. Some of these folks (not all, but some) did wonderful work. Investors occasionally participated by partnering with one or more appropriate contractors to buy, restore, and sell homes and small units. 

This article is for informational purposes only and is not 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 [email protected] 

If you’ve missed some of the prior articles, basic guidelines on successful investing are in my book “Stairway to Wealth” available at