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 28: This is not a difficult scenario to imagine. We’ve just passed through a period when interest rates were artificially maintained at, someone wrote, “the lowest in 5,000 years”. Rates are now climbing. It is not unreasonable to believe that every credit-worthy person and every credit-worthy company who was willing and able has already refinanced their loan(s) and even opened new credit facilities. There is good reason borrowers did that: money was cheap. There is equally good reason lenders cooperated: cheap money is (by definition) risk-free money. But now rates are climbing and risk is stirring. Payments easily made when the 10 year Treasury rates were 1.50% (July, 2016) are a little more difficult when they approach 2.50%. That may not sound like much, but it is a 67% increase. It is fully equivalent to the interest on 8% money going to a bit over 13%. The higher rates climb, the more business lines of credit are reduced (mostly over the borrower’s objections). Factoring costs more. New automobiles are offered at 72 months interest-free financing and there are fewer takers. Foreclosures are again 3-to-a-block. Lending money becomes riskier, and riskier money is more expensive. When interest rates climb, values drop. When values drop, the economy tends towards the deflationary. The potential is much worse than 2008 Housing Bubble because, due to a decade of historically low rates, every sector of the economy is now overborrowed. That makes every sector vulnerable. The dystopians may be proved optimistic.
Emily started this theme by wondering how a person could turn such a dark future into lemonade. She now saw that monetizing her assets, so she would have the cash available to make new investments at very friendly prices sometime in the future would be, probably, a reasonable step. She also knew she’d never do that because she lacked the most essential data point: “when”. Knowing that something will happen (the Sun will burn itself out) is not actionable until you know when it will happen (on Tuesday). Knowing” when” makes all the difference. To be actionable, both the event and the time it will occur must be known. We know only that eventually another recession will happen and it may not be limited to only one or two sectors of the economy. It will probably be severe (ie, widespread). We know we should be prepared for it, as much as we can. But that knowledge cannot be acted upon just yet because we don’t know “when”.
Emily knew that theoretically in these matters, it was better to be a year too early than a day too late, but she still felt no urgency. Maybe those optimistic forecasters were right, and the economy would continue to perk along quite nicely for a couple of years or perhaps even more. If it was really going to happen, somebody would know when and it would be published in one of the business websites she monitored. Emily decided her best option was to employ watchful waiting. Her mood lightened as she emptied the last of the moscoto.
The next morning Emily had two Tylenols with her coffee. Waiting for the pills to take effect, she turned on the kitchen radio and sat at the breakfast table to let the morning sun bake her shoulders. After awhile her headache began to diminish and she found herself paying attention to what the radio station was discussing: the next recession. It seems like everybody, including Emily herself, was thinking about that. Whenever it happens it would be her first recession as a landlord, and now that she had some assets she didn’t want to lose them.
She hadn’t recognized the voice on the radio, but most of his narrative was about investing in stocks rather than real estate. His thesis was that over long periods stocks provided a better return than income properties. Emily’s headache was better, but not yet gone. She paid as much attention as she could, given her condition.
RadioVoice talked about a $1,000,000 property that went down in value during the next recession, and then recovered to $1,160,000 would be an inadequate investment. He assumed five years between purchase and recovery. In this example, he said the appreciation would barely keep up with 3% inflation. In other words, almost all of the $160,000 gain would simply vanish in the miasma of higher costs of living and the owner would be no further ahead (and perhaps even behind if inflation was greater than 3%).
Emily was grateful, as Tylenol usually worked quickly for her. She put an egg on to soft-boil and dropped a slice of pumpernickel into the toaster. In a short time she was having breakfast, the sun still on her shoulders.
Between sips of hot coffee – she stirred it with a twig of cinnamon, something she learned from an old boyfriend (what was his name?) when he took her to Big Sur one holiday weekend – Emily realized that RadioVoice’s analysis of income property was very flawed: (a) no credit was given for tax savings or cash flow and (b) he presumed no loan on the property. That last one was a big mistake, because having suitable loans are a BIG part of portfolio management.
Inflation vs. Property Values
Given adequate maintenance, most well chosen income properties nearly always increase with inflation. That’s “most” because not every income property does. As one example, the value of triple net investments does not always adjust with inflation. Basically, the value of a NNN leased property would not adjust with inflation if (contractual) increases in the net rental income were not equal to or greater than inflation.
Think of Ol’ Victor, for example. He didn’t start investing in apartments until his early 40’s because his two daughters consumed all the family’s discretionary cash flow. But now it’s thirty years along and he’s tired of tenant phone calls, tired of building maintenance, and tired of unit vacancies. Then he got a glossy postcard in the mail and called the number at the bottom.
The guy who picked up the phone sold triple-net properties. A NNN property is one where the (often, corporate) tenant is responsible for the real estate taxes (the first N), insurance (the second NN), and maintenance (the last NNN). As this was explained to him – no tenant phone calls; no maintenance and it’s a 30 year lease, so no vacancy problems – Victor thought he’d died and gone to heaven.
Major drug stores are often sold on a lease-back basis to people like Victor. It is the sort of property a very cautious investor might buy, the sort of thing that might be an (income) substitute for bonds. Like bonds, the net cash flow from sound NNN leases has a low risk of default. The initial incentive to buy a NNN leased property might originally be a greater yield than the investor could get on a long term bond.
Thing is, because there is little or no credit risk the tenant (not the landlord) can pretty much write the lease to favor themselves. A common lease clause only provides for token rental increases, even when leases run for decades. It’s not unusual to see a 2% annual (or 10% every 5 years) increase. Adjustments don’t always start immediately. Sometimes the adjustments don’t kick in until the 11th year. That means a 30 year lease would have only 20 years of rental adjustments. This would mean that the lease would provide for raises totaling 40% over twenty years (2% a year, simple). A 40% increase may sound appealing until one realizes that inflation between 1987 and 2017 was 122%.
Ol’ Victor didn’t care. He was up-to-here with tenants, maintenance, and vacancies. Ol’ Victor, who loved what he was hearing, bought a NNN drug store. The purchase made him so happy he couldn’t stop himself from bragging to the other couple at the bridge table.
A few years later, Ol’ Vic’s menopausing wife suddenly grew very tired of penny-pinching. He’s still bold talking to their few (remaining) friends about how much money they’re worth, but she continues doing the family laundry at the public coin-op place. She’s also doing her own manicures, colors her own hair, and changes her own oil. One evening, on the way home after yet another bridge game, she announced, “We really have that much money? Truly? Then I’m going shopping, Victor. And you’re going to follow me slowly, in a very large truck.”
Uh-Oh. Time to sell the drug store.
Thing is, interest rates have gone up but the net income on Ol’ Vic’s building hasn’t. It is still in that 10 year flat rate period. He paid $3,000,000 for the drug store. It nets him $120,000 a year (a 4% yield) and is no longer worth what he paid for it. Nobody’s going to buy a stream of income yielding 4% when the current market offers 6%. At present yields, Vic’s $120,000 income is worth only $2,000,000. ($120,000 divided by .06)
Ooooops! He better tell her, “I don’t think we’ll need a truck. The car will be enough, but maybe we can make two trips”.
So RadioVoice was right in one limited respect: the value of a NNN investment, with no rent increases linked to inflation, may not keep up with the cost of living. But if we consider apartment buildings, where NNN leases are almost unheard of and the net rental income can adjust with inflation, then it’s probably true that well-located apartments almost always keep up with inflation.
Returning to RadioVoice’s example, a $1,000,000 property that appreciates to $1,160,000 over a period (say, five years) when total inflation was 16% has automatically kept up with inflation. That, by itself, is pretty special. There are not many equivalent investments that will do it. And if the property were leveraged, it might do even better.
For example, if that $1,000,000 income property (now worth $1,160,000) had been financed and was purchased with (hypothetically) $320,000 down, then during that five year period the owner would have made $160,000 on $320,000 of her own money. Inflation during that period was 16%, but considering only her investment, she made 50% on her down payment.
The value of a property bought for cash (as in RadioVoice’s example) will pretty much automatically keep up with inflation, but if the property is mortgaged the leveraged owner could actually gain inflation-adjusted wealth as inflation increases. It is possible to make Very Much Money on leveraged apartments if the underlying mortgage is favorable. That might explain, at least in part, why so many apartment owners are refinancing now.
But not all refinancing is equal. The Big Banks are splendid at doing standard / common / typical loans that fit a certain standard / common / typical profile. But what if your loan doesn’t quite fit into the right box? A loan officer employed by the Big Bank can only sell the products offered by the Big Bank. He won’t be able to help you. If his bank doesn’t offer it, he can’t make it available to his clients. So sorry. “Next in line, please!”
Fortunately, for borrowers with non-standard / uncommon / atypical needs, there are several niche lenders out there that do mortgage loans the big banks don’t. A good independent loan broker who’s been around a while has access to all the Big Bank mortgage programs, but also will have resources that are not available from Big Banks. Don’t want to show your tax returns? There’s a lender for that. Need “rush” service? There’s a lender for that. Buying out of state? There’s a lender for that. Want a multi-million fixed rate loan that’s fully amortized? There’s a lender for that.
So RadioVoice was right in the very narrow sense that if rent can’t be adjusted for inflation, the building value won’t be either. In the larger universe of the usual rental agreements for apartments, inflation adjustments are possible every time a new lease is signed. This means the building routinely increases with inflation.
The careful owner can take advantage of this through prudent refinancing.
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 [email protected]. This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional.