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

Continued from Part 23: It had taken her a touch over five years, but she now had bought and sold a commercial SFR that she had transformed into a day-care center, and renovated (and kept) a fourplex (each unit now with three bedrooms) and built / rebuilt a two-houses-on-a-lot duplex. They were franchise buildings (due to the number of bedroom / bathroom suites) in a modest archipelago. As usual she spent her birthday that year alone, reflecting on what she’d accomplished. That evening her favorite movie was playing on the Turner Classic channel. Emily opened a bottle of Beringer Chardonnay and took it to bed with her. She turned on the TV and clicked through to Casablanca.  When the movie ended she rolled over and went to sleep, leaving the empty wine bottle on the side table. 

When she started five years ago she had nothing, but aspired to eventually having 10 mortgage-free units. She now had six franchise units (albeit heavily mortgaged). Only four more units to go, then the challenge would be to pay them off. Ten free-and-clear units would give her a reasonable retirement, maybe by her fortieth birthday.

The Secular Interest Rate Cycle                             

Understanding how something happened is important to making it happen again. Emily had never really thought very deeply about the principals of investing before. She certainly hadn’t given them much thought prior to buying her first SFR. She only bought that rental property because she saw what her girl friend, Banana Pudding, had accomplished and Emily wanted to do the same. Several years had now passed and Emily’s assets had grown, but she was still not yet moved to really think about how the growth happened. But the day after her birthday she woke up and was no longer satisfied with trying to find the odd acorn. She wanted some guidelines to developing wealth. With appropriate guidelines in place, Emily realized, she would not have to always reinvent the wheel. The effort led her to reflect on some of the drivers (plural, because there are more than one) of a growing property portfolio.

Emily was still working in a property management office and she had, over the past several years, talked to a number of the more consistently successful owners. She was happily surprised to find they were usually eager to talk to a sincere young-investor-in-training. Emily would write what she remembered of the conversation in her Journal when she returned home. On this day she opened some of her older journals and re-read her notes. They were easy to find. She’d drawn little green stars beside each lesson.

Prices fluctuate based largely (but not exclusively) on changes in the current interest rates. The prices of all long-lived items vary over time. Sometimes they go up. Sometimes they go down.  Homes, investment properties, stocks and bonds, serious art, jewelry, etc are all affected by supply and demand. Supply and demand are, in turn, determined by interest rates.

Low rates stimulate both supply and demand. From the supply perspective, a developer is far more likely to create new buildings when money is cheap. And low rates, in turn, encourage demand. It’s a lot easier to afford the payments on an expensive property when rates are low.

The “secular” cycle.  Interest rates follow different cycles, with the greatest impact on a long-lived investment due to the secular cycle. The secular cycle completes itself over a long period, sometimes 30 or more years in length. It is composed of two halves: the front half where rates climb and the back half where they ratchet down. The most recent back half-cycle is the period which began in October, 1981, when the Freddie Mac rate for a 30 year mortgage was quoted at 18.45%.  Rates subsequently declined to 3.44% (August, 2016). This long term decline in rates had an enormous effect on asset values. See Examples, below.   (http://www.freddiemac.com/pmms/pmms30.html)

Example 1:  An apartment building has an annual NOI of $100,000. The building was purchased in October, 1981, when interest rates were high (and values were low).  The $100,000 annual stream of net income generated by the building was capitalized at 18.45% and the value was determined to be $542,000.  (NOI divided by 0.1845).

Example 2:  Interest rates subsequently trended down. The value of the $100,000 NOI purchased in Example 1 (above) increased as it was capitalized at ever-lower rates. By August, 2016, rates had bottomed out (and values were highest). The market now valued the building’s $100,000 NOI at a 3.44% yield. The building was now worth $2,900,000 (rounded).  The math is: NOI divided by 0.0344.

Discussion.  The point of these examples is to illustrate the impact of down-trending capitalization rates. To that end (and totally unrealistically), the NOI was stipulated to be unchanged over the entire back half of the secular rate curve: the NOI did not change over the entire 35 years. Even without a growing NOI, the market value of that original stream of income increased five-fold (a compounded implied yield of 4.9%) due solely to a fortunate purchase early on the back half of a declining secular interest rate curve.

It also works the other way.  It’s entirely possible for an investor to buy at the peak price (bottom of the interest rate curve) and sell at the bottom price (top of the interest rate curve). There is always somebody who does this. In that case, the hypothetical purchase would be made at $2,900,000 – and using the earlier figures, with no increase in NOI over the entire holding period – sold years later for $542,000.

Frequency.  Realistically, an investor will probably experience only a single secular cycle during his investment career. It may be a portion of the back half of one (that could be where we are right now) and a portion of the front half of the next, but it’s still only a part of one complete cycle. And where one buys in the secular interest rate cycle determines whether the investor is swimming with the tide or against it.

Of course, for some long term investors that doesn’t make much difference because the investor won’t be investing long enough to see the beginning of another secular cycle.

The back half of the most recent cycle lasted 35 years. That does not, however, mean that a complete cycle would ramble along for 70 years. The halves are not symmetrical.

This last secular cycle began in 1978 when mortgage rates first climbed into the double-digits. In November of that year they were 10.11% and in December 10.35%. From that point mortgage rates incrementally rose until October, 1981, when they peaked (as noted above) at 18.45%.

Thus the front half (rising rates) of the last cycle required three years to complete, followed by the back half (when rates were falling) which took an additional 35 years. The complete cycle consumed 38 years. The thing to remember about the last cycle is its asymmetry: the period when property values were falling consumed only 3 years of the entire cycle. The glorious period of falling rates and rising values took 35 years to complete. Future cycles could vary enormously, with some being much briefer and others perhaps even longer.

An investor has to pretty much take the secular cycle as he finds it. If rates-are-low-and-prices-high it would be expected that at some point reversion to the mean would settle in. The low rates would begin to trend towards (or even beyond) their long-term median. During this period the investor understands that anything he invests in will be facing headwinds. Some people think we’re approaching the front half of a rising interest rate cycle right now, and it may be true.

One way to deal with rising rates. If the investor believes the proportional asymmetry of the last cycle was typical (ie, values trend down for 3 years and up for 35 years), he could simply wait it out. Three years is not forever, and he still has the cash flows and increasing equity build-up from his portfolio. He can still buy his wife any purse she likes. And he has incurred none of the transaction costs that come with buying and selling. Most people probably should at least consider just waiting it through.

Another way to deal with rising rates. The only value of income properties is their (net) income. Although this was not her motivation at the time, Emily offset part of an adverse change in interest rates by increasing the density of her properties. Typically, higher density means greater revenue. There may be a number of ways to increase density. Emily chose the following three:

The Day Care SFR: No change in living area. An old, vacant single-family residence on a busy street was repurposed into a commercial children’s day care center. Leasing the property to the day care operator brought Emily a much greater cash flow than renting to one family. When she sold the property to the operator Emily monetized the higher stream of income and came out of it very well, thank you very much.

One Bedroom Units into Three’s: Still no change in living area, but greater utility.  Emily’s second purchase was of an older fourplex, each unit having one large bedroom. She moved the partition walls, reduced the size of each room a bit, and turned the four 1’s into four 3’s. People pay a lot more for three bedroom units than for one bedroom’s. Once again, increasing density significantly enhanced the gross income.

The House in Back: Added living area, added utility. After refinancing her fourplex and pulling some money out to fund her next purchase, she found a deep lot in a good school district with one old house in front. Emily worked with her loan broker (for the funding) and a contractor (for the physical changes) to renovate the front house and build a second house in back. Both houses now had two bathrooms with 3 bedrooms (front house) and 4 bedrooms (rear). The increased density meant the property gave Emily another splendid cash flow.

Discussion.  The long term (secular) interest rate cycle drives value. When rates go up, values go down. In the last cycle, the rising-rate portion was only three years. It might be possible to just wait that period out. Alternatively, an investor might wish to add density to an existing site with the intent of increasing the property’s net income. In this case he would begin the back half of the cycle (when rates go down and values go up) with a higher net income from his portfolio, and the potential for greater capital gains as rates enter their lengthy down-trend.

 

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; BRE: 00957107  MLO: 249261. If you are thinking of refinancing or purchasing real estate, Klarise Yahya can probably help. Find out how much loan the building will support. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email Info@KlariseYahya.com. This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional.