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 29So 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, 5 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’s 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. 

Past Performance is No Indication of Future Results

Everyone knows there are different kinds of people. One kind goes through life looking at the rear view mirror, muttering to herself “Oh! I’m such a ninny! I should never have done that. I knew it would be wrong, what made me do it? And another thing . . .”

The other kind of person keeps her eyes on the future. The past is past and trying to change it means you will miss the Kardashians.

While it’s useless to try to change the past, the future can sometimes be managed. Emily was a “future-oriented” kind of person. Being a single woman with no familial safety net, a large part of her life had been spent trying to influence what might happen. Would she be able to get into her red leather skirt by Saturday night? Would she have a date for Richard’s party? Will that disgusting Jennifer, who can’t keep her goo-goo eyes off Richard, be there? In limited ways Emily had developed pretty impressive forecasting abilities, so she already knew the answers: No. No. Yes.

Most of the time events proved the (slight) majority of her near-term expectations correct, and this gave her the confidence that she really could look at the data and sometimes even extrapolate further into the future. While she may be pretty confident of what might happen, she had absolutely no idea when it might be. “When” was way out of her skill set. There were those few people who argued that “If you don’t know when, then what you say is not actionable and has no value”, but Emily tried to not associate with dreary people like that.

While her vision was towards what might lie ahead, Emily understood that the ever-approaching future was forever linked to the past. To foresee future things meant to understand at least some things that happened in the past. It’s the “the future doesn’t repeat itself, but it rhymes” sort of thing. This restricts the range of possibilities to a reasonable number and increases the chances of success. 

Interest Rates and Investment Values

The most influential monetary policy in the recent past has been the government’s compression of interest rates. Interest rates affect both supply and demand. They also affect when the knowledgeable investor expects to receive a return. Let’s talk about that last one.

When rates are low and demand is high, investors expect windfall profits upon sale of the investment.  Assume a building having a $300,000 NOI is purchased for $10,000,000. The cap rate is 3%. Over the next couple of years, if the investor can increase the NOI to $360,000 the building would be worth $12,000,000 ($360,000 divided by .03). While he may not be interested in tying up his money for a measly 3% annual yield, a 20% return in a year or two looks pretty good. When an investor buys at a low yield, the expectation is generally for a large return at re-sale.

It’s different when rates are high and demand is low. If that same $300,000 were capitalized at 15% the building would be worth $2,000,000 ($300,000 divided by .15). At an NOI of $360,000 the value would be $2,400,000. While the investor might not be interested in tying up two million dollars for who-knows-how-many-years to get a final gross profit of $400,000, getting an annual yield of 15% per year is awfully hard to turn down.

Emily realized that, yes, interest rates (and cap rates) cycle. When they’re high the investor’s return is disproportionally weighted towards current income.

When rates are low, the investor’s return comes when the asset is flipped. That’s what’s been happening on the back half of the current interest rate cycle, when rates have trended down (and values increased) for 35 years (1982 – 2017). Bonds, income properties, stocks, and vintage Ferraris shot up in price. People became conditioned not to expect high cash flows, but to anticipate high returns at resale. 

Now What?

Emily recognized that the economy is now on the back half of the current secular interest rate cycle. Things that went up will start to revert back towards their mean, and maybe even past their mean. Formerly costly assets will become cheaper. 

A Visualization

Imagine a long line outside the only $3.99 sandwich shop in town. Suddenly the biggest man you’ve ever seen appears and waddles his huge mass forward, toes pointed out, thighs rubbing each other. He cuts right in front of the line and begins ordering sandwiches by the wagonload. When he’s done, the store has only a couple of sandwiches left. Who gets one?

Orderly lines won’t work: they anticipate sufficient supply. Why stand in line for seven hours if you know the store will be sold out in 20 minutes? If supply is thought to be inadequate, why not just run to the front and mob the store?

That’s where the auction system comes in. In an auction system the sandwiches go to the people who offer to pay the most. While the auction system doesn’t always work everywhere for everything (nothing does), it does tend to work for marketable financial assets. Imagine that the fat man is the Federal Reserve. The Fed has been buying assets with both hands for the past decade. In combination with compressed interest rates, this has resulted in higher and higher prices for the remaining assets.

Now consider that the Fat Man comes back to the sandwich shop and returns all the sandwiches he’d purchased earlier. There are now enough sandwiches for everybody. What happens to sandwich prices? That’s right: they plummet. Supply and demand again. The US Federal Reserve has announced that they will begin selling their marketable assets in the near future. The Fat Man will be returning the sandwiches. Close your eyes and you can hear the rubbing of his thighs.

There are many reserve banks. The U.S. Federal Reserve is one of the biggest, but there’s also the Bank of England, the Deutsche Bundesbank and, for those that prefer neighborhood banking, the Bank of Eriteria. When smaller reserve banks see that the Popular Girls are selling assets, the little reserve banks can be expected to dump their assets too. Suddenly we’ve gone from “teeter-totter” to “follow the leader”. If the smaller reserve banks don’t, the prices of their assets will continue to erode. So they might as well sell for whatever they can right now. The assets will be worth less tomorrow and even less the next week. “Dump ‘em now, Yonas! Maybe we’ll buy ‘em back when they stop dropping”

And that, Emily thought, was one possible way the next recession might start. Something (nobody knows what) happens to upset the equilibrium of the market. Assets take a dip. Central bankers lose their composure and sell everything they’ve got, slowly at first, then in panic mode. She thought it will be like Bill and Mike (The Sun Also Rises): “How did you go bankrupt”, Bill asked. “Two ways”, Mike said, “Gradually, and then suddenly”.  Banks don’t like to go broke at all, but especially not suddenly. For individuals, the opposite of excitable central bankers is Kenny Roger’s song “The Gambler”. Emily liked to remind herself that: “The secret to survivin’ is knowing what to throw away and knowin’ what to keep.  The song continued …  Cause every hand’s a winner, and every hand’s a loser”.

These lyrics made her feel like maybe she really could make lemonade from lemons. People who can consistently do that tend to come out ahead of those who just go to their room and cry. In this case, Emily began to give much thought to how she might best get through what she saw as the inevitable approaching recession. 

What It Might Look Like

While there were no guarantees, she anticipated the fall would be abrupt (the “suddenly” part), with the recovery extended over several years. However, it’s not always that way. We had a “V” shaped recession in 2008-9 because interest rates at the beginning of the recession were high enough that they could be meaningfully lowered. The general finding is that the Fed commonly reduces rates about 5% before the economy passes through a recession. Rates are now much lower than they were in 2007. There is not nearly as much room for the Fed to maneuver. Dropping rates 5% would put us well into negative figures, and – although some countries have tried them – negative rates come with big difficulties. If there’s no room for rates to be lowered enough to kick-start a recovery the next recession, Emily thought, will be “L” shaped. If she was wrong, and it turns out to be another “V” recession, the best thing is probably to curl up with a good book and await the recovery. If she’s right and there’s a sudden drop followed by an extended recovery, there will be plenty of time to make splendid investments during the flatline. In either case, Emily saw no reason to rush.

There is a history of “L” shaped recessions. They don’t go on forever, but they can feel like they do. In 1968 the S&P hit 95.04 and closed a decade later, in 1979, at 99.71. Times like that are not pleasant for sellers. With no realistic expectation of flipping an asset the buyer’s only option was to buy based on current yield, and you know what that does to values. There were periods in the 1970’s when it was really good to be a buyer, and Emily was preparing herself to be a purchaser. She expected that an “L” shaped recession would provide many opportunities to acquire Very Good Deals. She was refinancing her properties now so she would have down-payment money available when the time came. In this way she hoped to come out the other side much better than when the recession started.

That song began going through her head again . . . ‘Cause every hand’s a winner”

 

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.