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 30:   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 flat line. 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” 

Historical Data and Rosenberg    

Gluskin Sheff is a Canadian wealth management firm. It is a small company organized in 1984 and became listed on the Toronto Stock Exchange under the symbol GS in 2006. Gluskin Sheff only came to Emily’s attention because David Rosenberg is their Chief Economist/Strategist. He was, for seven years previously, one of Merrill Lynch’s chief economists. And that is important because during those years he was regularly ranked with the All-Stars at Institutional Investor. You’re not listed on that page unless you take your vitamins.

Rosenberg is not always right. No one is. Rosenberg himself admits he’s wrong about 30% of the time. So he seems to be in that small bunch of forecasters that are right more often than they are wrong. Not many people can claim a record like that. His name was given to Emily with the recommendation that Rosenberg, who occasionally publishes on the web, was somebody she should heed.

He uses historical data to forecast future events. His preferred mechanism is via mean reversion (“Mean” is another word for “average”. Reversion to the mean: things that are cheap eventually rise to their average cost over time; things that are expensive eventually sink to their average cost over time) as a supportable approach to estimating the direction of large sets of data. Mean reversion doesn’t work for small sets: Frank is 74 years old. He will not revert to his mean and die at 37. Mean reversion does tend to work with appropriate large data sets. Frank is a member of the group “Senior citizens” composed of adults over 65. Data indicates that the group “Senior Citizens” will say “Whaat? Whaat?” a lot.

To this end, Rosenberg analyzes large sets of relevant data. He found that movement within data sets trends towards the long-term average. For this, he was a multiple All-Star. That is not meant to diminish Rosenberg in any way. Today, we would be surprised if someone would not know about mean reversion. But at one time it was entirely new knowledge, and very actionable. Brilliance is sometimes recognizing the obvious.

Although not an economist, Emily agreed that mean reversion sounded like a pretty good bet.

It’s clear that interest rates are currently still low by historical standards and it’s reasonable to think they will continue ratcheting up towards their long-term average, but that information is not fully actionable unless accompanied by a date. Reading, “Rates are climbing, but don’t worry. You’ll be in an assisted living facility before the next increase” is much different from “Welcome to Venezuela. Beginning tomorrow rates will go up 1% a day, with no end in sight”. Knowing the time when something might occur makes it actionable information. It’s important, even vital.

 

The Federal Funds Rate

The Federal Funds Rate is the annualized rate charged between banks to borrow money overnight. It is currently 1.42%, but the Fed has stated its intent to raise the Federal Funds rate a little at a time over the next year or two. Rosenberg expects the overnight rate to ratchet up two or three times this year and another three times in 2019.  The Fed usually (but not always) increases interest rates in quarter-point steps (one-quarter of a percent equals 25 basis points). Because the nominal 10-year Treasury rate consists of the overnight rate (i.e., the Federal Funds Rate) plus a margin, usually but not always, of 200 basis points or more (200 basis points is 2.0%), Rosenberg projects the 10-year Treasury to make six (06) quarter-point (i.e. 25 basis points) moves in the next year and a half or so, bringing the 10-year note to 4 to 5% by the end of 2019.

Mortgages consist of an index (often the 10-year Treasury) plus a margin over the 10-year Treasury of, commonly, 3%. Forecast Treasury rates 18 months from now would indicate mortgage rates of 7 to 8% in 2019.  Danger, Will Robinson!  Exactly when rates might rise to this level is uncertain. It may be tomorrow. It may be a long time from now. Rosenberg’s forecast date is at best an educated guess. 

What Does this Mean?  

Values are a function of interest rates. Interest rates go up, values go down. If it’s true that we’re in a-bubble-of-everything, and have been for a decade, then rising interest rates will reduce the value of almost everything. Very importantly, this includes the mortgage value of income properties.

Maximum Loan Payment: Let’s create a totally hypothetical example. Presume an apartment building with an annual Net Operating Income of $100,000. Emily remembered that once you get to NOI, the only remaining carve-out is for the mortgage payment (principal and interest). If you own the apartments free and clear, the NOI goes into your purse. If you have a mortgage, the payment comes out of the NOI and the rest goes into your purse.

Our hypothetical subject is a nice building in a nice area and the right lender will offer a loan at a Debt Coverage Ratio of 1.20 based on the NOI. Again, Emily recalled that when the monthly NOI is divided by the DCR, ($100,000 divided by 12 months divided by 1.20) the result is the maximum monthly loan payment.

Cash Flow: Subtract the loan payment from the NOI and you get cash flow. Example: NOI is $100,000 annually. Divide by 12 months and we get monthly NOI of $8,333. Divide monthly NOI by the Debt Coverage Ratio (in this example, 1.20) and we find that the maximum monthly loan payment the building will support is $6,944. (Write that number on a scratch pad, please. We’re going to use it later.) Monthly NOI ($8,333) minus loan payment ($6,944) leaves a monthly cash flow of $1,389 on the day the new loan is funded. Over time, this number is expected to improve, but right now its $1,389.

Note that a DCR of 1.20 means that 5/6ths of the NOI is allocated to the mortgage payment. One-sixth is cash flow to the owner.

Quick Test for Cash Flow: Given the above, if all a person knows is the NOI she could estimate cash flow at 1/6th of it. Quickie Test: Malakai sees a property he likes. The agent tells him the monthly NOI is $6,000. After the mortgage payments, what is his expected cash flow? Right. It’s $1,000.

Malakai’s wife, Ruth, is searching for property on the other side of town. She sees a property with six cute two-bedroom cottages on it. The agent says the NOI is $10,000 monthly. Ruth pulls out her cell phone and opens the calculator app. She punches in $10,000 and divides by 6, getting $1,667.  That’s her cash flow.

Slick little formula, huh?

Forecasting: Here’s another use for NOI and DCR. Rosenberg believes interest rates are going to climb. How will that affect the value of income properties?

Once we know the NOI and DCR, we can begin to estimate what happens to an apartment building’s value at a higher interest rate. Assume current rates are 5% and we’re preparing for a climb to 7.5%. That’s about the middle of what Rosenberg expects in 18 months. 

Example:

$100,000 annual NOI divided by 12 months equals $8,333 monthly.

Divide the monthly NOI by (in this case) a 1.20 DCR to get $6,944

At 5.0%:  $6,944 will support a loan of $1,293,500 (rounded). If the Loan to Value Ratio (the LTV) is 70%, borrower would be required to have 30% equity. A 70% loan plus 30% equity puts the property’s indicated value at $1,848,000 (rounded). That’s the sum of the loan amount plus the down payment.

At 7.5%:  The same $6,944 will support a loan of $993,000 (rounded) at 7.5% interest.  The required equity (down payment if this is a purchase, or retained equity if a refinance) is still 30% but the dollar amount of the required equity has shrunk to $426,000 (rounded). The property’s value at 7.5% interest is reduced to $1,419,000 (the total of loan plus down payment). When interest rates are at 5%, the value of the property is estimated at $1,848,000 (loan:  $1,293,500 plus equity: $554,500). But now that rates are at 7.5%, the increased interest rate has reduced the property’s value by 24% (rounded), down to $1,419,000 from the earlier $1,848,000. That’s a loss of a little over $400,000.    

Summary:  Everything else being the same, rising interest rates (as in the example above) will reduce loan values. If loan values decline it is not likely that property values will remain high. In this example, the effects of rising interest rates cut $429,000 off the value of the building.

Emily knew all this but was still unmoved.  She recognized that a rate-induced value loss was more than a possibility but she believed it to be less than a certainty. After all, maybe everybody’s wrong and rates won’t go up. Or maybe the value of all buildings will drop . . . except her’s. And besides, 18 months is a long time. She’d been waiting that long for Ralph to call.

In fact, Emily didn’t have to do anything and she would still be okay. Her rentals were all 4-units or less and had 30 year fixed rate loans. But even if she had commercial (adjustable) loans, they would be fully amortized. Once they clicked over into the adjustable rate period principal pay-downs could be made with no pre-payment penalty. At future higher borrowing rates, competition from new apartment construction would be reduced. The limited new competition might allow her to raise rents a little more, over time, than she otherwise could. Might. If she was hungry for more units she could refinance her properties now (not that rates are as low as they once were, but that forward rates will be higher) and tuck the proceeds away until the time is right. But that seemed like a lot of trouble and she wasn’t ready to do anything. Maybe later.

Evening was approaching. She turned on a light and reached first for the fudge brownies, then for that diet book someone told her about, “The Complete Guide to Fastingby Jason Fung, MD.

 

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.